Fiscal Policy and Macroeconomic Stability: New Evidence and Policy Implications

Abstract

The paper revisits the empirical link between fiscal policy and macroeconomic stability. Our basic presumption is that by definition, the operation of automatic stabilizers should always and everywhere contribute to greater macroeconomic stability (output and consumption). However, two stylized facts seem at odds with that prediction. First, the moderating effect of automatic stabilizers appears to have weakened in advanced economies between the mid-1990s and 2006 (the end of our main sample). Second, automatic stabilizers do not seem to be effective in developing economies. Our analysis addresses these apparent puzzles by accounting for the government’s ambivalent role as a shock absorber and a shock inducer for determinants of macroeconomic volatility over time. Results provide strong support for the view that fiscal stabilization operates mainly through automatic stabilizers.