A New Look into Fiscal Countercyclicality: Expectations, Shocks, and the Business Cycle

Abstract

This paper empirically revisits the debate surrounding the role of fiscal policy in dampening output fluctuations. We provide a positive analysis of fiscal stabilizers in general and automatic stabilizers in particular by focusing on a heterogenous sample of 84 countries between 1980 and 2015. We add to the existing literature by: i) explicitly assessing fiscal counter-cyclicality across the different states of the business cycle; ii) allowing for expectations about future fiscal outcomes to play a role; iii) differentiating between the counter-cyclical fiscal effects from demand and supply shocks. Our results show that that fiscal counter-cyclicality is sizeable across the world, particularly during periods of economic slack. While the degree of counter-cyclicality is larger in Advanced Economies relative to Emerging and Low-Income Countries, there is higher heterogeneity within than between country groups. Accounting for future expectations about the dynamics of the fiscal stance enhances the degree of fiscal counter-cyclicality. Automatic stabilizers are an important component of the overall fiscal counter-cyclicality. The fiscal response to demand shocks is higher compared to supply shocks.