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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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  • Claeys Peter & Maravalle Alessandro, 2011. "Fiscal policy and economic stability: Does PIGS stand for procyclicality in government spending?," wp.comunite 0090, Department of Communication, University of Teramo.
  • Handle: RePEc:ter:wpaper:0090
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    Keywords

    RBC; current account; small open economy; fiscal rule; spending;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • H62 - Public Economics - - National Budget, Deficit, and Debt - - - Deficit; Surplus

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