The Reaction of Government Spending to the Business Cycle: Some International Evidence

This paper studies how the spending side of fiscal policy reacts to the business cycle. I find that between 2000 and 2012, government spending is forward-looking in a number of countries—it reacts to forecasts of economic activity rather than to past economic realizations. I also study whether the response of government spending is countercyclical or procyclical. Spending responds countercyclically in countries such as the United States, Belgium, and Finland—when governments in these countries expect GDP to be below trend, they increase spending, and vice versa. In contrast, spending responds procyclically in places such as the United Kingdon, Argentina, and Ecuador—when governments in these countries expect GDP to be below trend, they decrease spending, and vice versa. The methodology I use exploits the fact that the government cannot forecast economic activity perfectly. The presence of shocks that cannot be forecast allows me to estimate reaction parameters under the framework of the Generalized Method of Moments.