Fiscal policy, business cycle, and economic stabilization

Abstract

The paper empirically investigates the responsiveness of fiscal policy to the business cycle and the effectiveness of fiscal policy in stabilizing the economic fluctuations. Using the economic fluctuations in neighboring countries as an instrumental variable, we show that the response of fiscal policy is more significantly counter-cyclical in OECD countries than in non-OECD countries. Among various components of expenditure and taxes, subsidy and transfer in OECD countries show a counter-cyclical response most strongly, suggesting that the social welfare system works as an automatic stabilizer. We also observe fiscal policy move asymmetrically over the business cycle, implying budget deficits can grow over economic fluctuations. In investigating the effectiveness of fiscal policy in stabilizing the economic fluctuations, we mitigate the omitted variable bias of previous studies by adding four important factors: oil production, military expenditure, the economic fluctuations in neighboring countries, and the responsiveness of fiscal policy to the business cycle. Effectiveness regression results are very consistent with responsiveness regression results, indicating the importance of expenditure, especially subsidy and transfer, in responding to business cycle and in stabilizing economy.