Cyclicality of Fiscal Policy: Permanent and Transitory Shocks

Joseph Zeira and Michel Strawczynski

No 7271, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper examines the optimal reaction of fiscal policy to permanent and transitory shocks to output in a model of tax and public consumption smoothing. The model predicts that optimal reaction of public expenditures and deficits to transitory shocks should be countercyclical, while optimal reaction to permanent shocks should be a-cyclical. Using the Blanchard and Quah (1989) methodology for identifying permanent and transitory shocks, we test these predictions for a sample of 22 OECD countries over the years 1963-2006. We find that both expenditures and deficits are countercyclical to transitory shocks, mainly through public transfers and mainly in recessions. We find that government investment is pro-cyclical with respect to permanent shocks, but total expenditures are not.

Keywords: Business cycles; Fiscal policy; Permanent and transitory shocks (search for similar items in EconPapers)
JEL-codes: E32 E61 E62 (search for similar items in EconPapers)
Date: 2009-04
New Economics Papers: this item is included in nep-cba and nep-mac
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Citations: View citations in EconPapers (12)

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