Cyclicality of Fiscal Policy: Permanent and Transitory Shocks
37 Pages Posted: 9 Apr 2009
Date Written: April 9, 2009
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 counter cyclical, 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 counter cyclical 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
JEL Classification: E32, E61, E62
Suggested Citation: Suggested Citation