Fiscal policy and economic stability: Does PIGS stand for procyclicality in government spending?

Peter Claeys and Alessandro Maravalle

wp.comunite from Department of Communication, University of Teramo

Abstract: The Financial Crisis has hit particularly hard countries like Ireland or Spain. Procyclical fiscal policy has contributed to a boom-bust cycle that undermined fiscal positions and deepened current account deficits during the boom. We set up an RBC model of a small open economy, following Mendoza (1991), and introduce the effect of fiscal policy decisions that change over the cycle. We calibrate the model on data for Ireland, and simulate the effect of different spending policies in response to supply shocks. Procyclical fiscal policy distorts intertemporal allocation decisions. Temporary spending boosts in booms spur investment, and hence the need for external finance, and so generates very volatile cycles in investment and the current account. This economic instability is also harmful for the steady state level of output. Our model is able to replicate the relation between the degree of cyclicality of fiscal policy, and the volatility of consumption, investment and the current account observed in OECD countries.

Keywords: RBC; current account; small open economy; fiscal rule; spending (search for similar items in EconPapers)
JEL-codes: E32 E62 F41 H62 (search for similar items in EconPapers)
Date: 2011-12
New Economics Papers: this item is included in nep-dge, nep-eec and nep-mac
References: Add references at CitEc
Citations: View citations in EconPapers (31)

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Related works:
Working Paper: Fiscal policy and economic stability: does PIGS stand for Procyclicality In Government Spending? (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:ter:wpaper:0090

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