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Fiscal Policy and Economic Stability: Does PIGS stand for Procyclicality In Government Spending?

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  • Claeys, Peter
  • Maravalle, Alessandro

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.

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Paper provided by University of the Basque Country - Department of Foundations of Economic Analysis II in its series DFAEII Working Papers with number 2010-11.

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Date of creation: Dec 2010
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Handle: RePEc:ehu:dfaeii:201011

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Postal: Dpto. de Fundamentos del Análisis Económico II, = Facultad de CC. Económicas y Empresariales, Universidad del País Vasco, Avda. Lehendakari Aguirre 83, 48015 Bilbao, Spain
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Keywords: current account; small open economy; RBC; fiscal rule; spending;

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