Abstract :
This paper analyzes the effect of terror on the economy. Terror endangers life such that the value
of the future relative to the present is reduced. Hence, due to a rise in terror activity, investment goes
down, and in the long run income and consumption go down as well. Governments can offset terror
by putting tax revenues into the production of security. Facing a tide in terror, a government that
acts optimally increases the proportion of output spent on defense, but does not fully offset the tide.
Thus, when terror peaks the long run equilibrium with an optimizing government is of lower output
and welfare. Next, we show that this theory of terror and the economy, helps to understand changes
in trend and business cycle of the Israeli economy. The estimates show that terror has a large impact
on the aggregate economy. Continued terror, at the level of the death toll by about the same size as
due to car accidents, is expected to decrease annual consumption per capita by about 5% in 2004.
Had Israel not suffered from terror during the last 3 years, we estimate that the output per capita
would have been 10% higher than it is today.
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