Chapter

3 Cyclicality of Fiscal Policy

Author(s):
Manmohan Kumar, and Teresa Ter-Minassian
Published Date:
October 2007
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Author(s)
Fabrizio Balassone  and Manmohan S. Kumar  

Although some debate on the feasibility and effectiveness of fiscal policy in stabilizing output fluctuations continues, there is little disagreement that, as a rule, policy should not be procyclical. The standard Keynesian approach suggests that fiscal policy should act in a stabilizing manner, while within the neoclassical paradigm, tax-smoothing models imply that fiscal policy should remain neutral over the business cycle. Even in a Ricardian framework, where a reduction in taxes or an increase in spending leads to an equivalent rise in private sector saving, policy would not be expected to be procyclical.

Nonetheless, procyclical policies may sometimes be warranted by the need to preserve the sustainability of public finances. Sustainability considerations can become overriding during economic downturns if public debt is not at prudent levels initially. This can be especially relevant for emerging market and developing countries facing an intrinsically more volatile macroeconomic environment and uncertain access to international capital markets. In the absence of adequate financial buffers, and constraints on borrowing, expenditure retrenchment in the downturn may be necessary.

Yet there is no room for complacency regarding chronic procyclicality—and, in particular, systematically exuberant spending in good times—as this exacerbates volatility and damages fiscal sustainability. Although economic theory is ambiguous with regard to the impact of volatility on growth, most empirical studies find an inverse relationship, reflecting in part the adverse effect of volatility on capital investment and human capital formation. While weaker growth itself can jeopardize fiscal sustainability, a policy that is procyclical in good times can directly fuel debt accumulation as deficits incurred in downturns are not compensated for by surpluses during the rebound.

However, there is empirical evidence that fiscal policy is frequently pro-cyclical, especially in upturns. This reflects a variety of economic, financial, and political factors. One explanation hinges on lags in the formulation and implementation of policy and difficulties concerning the assessment of the state of the cycle; another is based on the interaction between budgetary decisions and political economy factors, and emphasizes the political dimension of spending pressures arising in good times, with fiscal expansion in the upswing reducing room for countercyclical policy in the downturn. In developing countries, this effect is compounded by financial constraints and limited access to international capital markets. In these countries the need to make up for the compression in spending during downturns can in turn add to spending pressures in good times, resulting in a vicious cycle of procyclical policies.

This chapter examines the cyclical properties of fiscal policy and explores three issues: the extent of procyclicality in both industrial and developing countries; the factors underlying the observed pattern of procyclicality; and the consequences of procyclicality, including the impact on countries’ debt ratios. The analysis finds that discretionary fiscal policy has generally been procyclical in good times in both industrial and developing countries, and that it has adversely affected both economic growth and budgetary sustainability.

Evidence on Procyclicality

Movements in the ratio of nominal fiscal balance to GDP are the net result of the automatic reaction of the budget to cyclical developments and discretionary policy. Hence, movements in nominal balance, while providing important indications regarding the cyclicality of the budget and budgetary sustainability, do not show the policy stance. For instance, an improvement of the fiscal balance in a cyclical upturn may yet entail a procyclical (expansionary) stance if there are sufficiently large automatic stabilizers.

There is significant evidence that discretionary policy tends to be procy-clical in both industrial and developing countries. In industrial countries, movements in the ratio of overall fiscal balance to GDP are seen to be mildly countercyclical (see, e.g., Mélitz, 2002). In developing countries, the sensitivity of the fiscal balance to the economic cycle is generally low (IMF, 2003). But there are considerable differences across regions, with the sensitivity being lowest for the Latin American countries. In both industrial and developing countries, the cyclical sensitivity of nominal balances appears lower than would be expected based on the effect of automatic stabilizers alone, suggesting that discretionary policy exerts an offsetting impact.

Recent, more systematic, analysis undertaken by the authors corroborates the above evidence. For industrial countries the results indicate that on average a 1 percentage point increase in the output gap results in an improvement of around 0.3 percentage point of GDP in the overall fiscal balance (Figure 3.1 and Table 3.1).1 Since the available estimates suggest that the effect of automatic stabilizers averages around ½ percent of GDP (van den Noord, 2000; Bouthevillain and others, 2001; and IMF, 2004), discretionary policy is seen to be procyclical. For developing countries our estimates indicate that the sensitivity of the overall balance to the output gap is close to zero. While the size of automatic stabilizers is certainly smaller in developing countries, it is unlikely to be zero or negative, again indicating procyclicality of discretionary policy.

There is also evidence for both industrial and developing countries that discretionary policy is asymmetric, with procyclicality mainly occurring in good times. It has often been remarked that in member countries of the European Union during 1970–2000, deficits increased in downturns, but did not fall in periods of high growth, with the countries offsetting the effects of automatic stabilizers via tax cuts or, more often, expenditure increases (see European Commission, 2001). The procyclicality of fiscal policy in good times is also a stylized fact in emerging market countries and, specifically, in Latin American countries. For the latter, there is considerable evidence that procyclical fiscal policy partly reflects procyclical capital flows (Kaminsky, Reinhart, and Vegh, 2004). Such policy is also evident during recessions, when access to markets dries up, interest rates rise, and currencies weaken (Gavin and others, 1996; and Budnevich, 2002).

Our analysis illustrates that in good times the effect of automatic stabilizers is generally offset by discretionary action, while, in general, this is not the case during downturns. In industrial countries, when output is above potential, changes in the output gap are generally seen to have no effect on the ratio of the overall fiscal balance to GDP, indicating that procyclical discretionary policy fully offsets automatic stabilizers. However, when output is below potential, a 1 percentage point worsening in the output gap results in a deterioration of ½ percentage points of GDP in the overall fiscal balance, in line with available estimates of the effect of automatic stabilizers (Balassone and Francese, 2004). For developing countries, the asymmetry is even more striking: the fiscal balance moves procyclically in good times, when procyclical discretionary policy appears to be stronger than the automatic stabilizers, and countercyclically in bad times. The analysis does not appear to suggest that, on average, discretionary policy is procyclical in bad times in emerging market countries. However, this result masks significant cross-country variation: countries that were not financially constrained tended to pursue countercyclical policy, while in others financial constraints led to a procyclical tightening.

Figure 3.1.Sensitivity of the Fiscal Balance to the Output Gap1

Source: IMF staff calculations.

1 Budgetary response to a 1 percent change in the output gap. For details on the sample and estimation see footnotes to Table 3.1. The estimate of the size of automatic stabilizers for developing countries is based on average values of expenditure and revenue ratios to GDP.

Table 3.1.Cyclicality of Fiscal Policy 1
Industrial CountriesDeveloping Countries
OverallOverallOverallOverall
Dependent VariablebalancebalanceExpenditurebalancebalanceExpenditure
Constant−3.08**−2.72**7.80**−1.02**−0.449.83**
(0.40)(0.45)(1.43)(0.18)(0.25)(1.43)
Lagged dependent variable0.70**−0.71**0.84**0.52**0.51**0.51**
(0.05)(0.05)(0.03)(0.04)(0.04)(0.06)
Lagged debt0.03**0.03**0.02**
(0.006)(0.006)(0.005)
Output gap20.30**0.07
(0.06)(0.04)
Positive output gap0.090.06−0.16*0.29*
(0.13)(0.11)(0.08)(0.14)
Negative output gap0.52**0.40**0.29**−0.52**
(0.13)(0.12)(0.08)(0.15)
R2 within0.6310.6370.7790.3000.3210.314
Between0.9120.9130.9930.9840.9690.995
Overall0.7750.7800.9650.5790.5790.730
Number of observations221221218370370195
Number of countries121212212113
Source: IMF staff calculations.

Methods of estimation: Ordinary least squares, fixed effects; standard errors in parentheses; * and ** indicate significance at 5 percent and 1 percent levels, respectively. Estimation period: 1975–97. Industrial countries: Australia, Austria, Belgium, Canada, Denmark, France, Italy, Japan, the Netherlands, Norway, Spain, Sweden, and the United Kingdom. Developing countries: Argentina, Brazil, Chile, China, Czech Republic, Hungary, India, Indonesia, Kenya, Malawi, Malaysia, Mexico, Nigeria, the Philippines, Poland, Singapore, South Africa, Thailand, Turkey, Uruguay, and República Bolivariana de Venezuela.

Hodrick-Prescott filtered real GDP (lambda = 30), sample 1970–2002.

Source: IMF staff calculations.

Methods of estimation: Ordinary least squares, fixed effects; standard errors in parentheses; * and ** indicate significance at 5 percent and 1 percent levels, respectively. Estimation period: 1975–97. Industrial countries: Australia, Austria, Belgium, Canada, Denmark, France, Italy, Japan, the Netherlands, Norway, Spain, Sweden, and the United Kingdom. Developing countries: Argentina, Brazil, Chile, China, Czech Republic, Hungary, India, Indonesia, Kenya, Malawi, Malaysia, Mexico, Nigeria, the Philippines, Poland, Singapore, South Africa, Thailand, Turkey, Uruguay, and República Bolivariana de Venezuela.

Hodrick-Prescott filtered real GDP (lambda = 30), sample 1970–2002.

Expenditures appear to play a preponderant role in determining the cyclical asymmetry of fiscal policy. In industrial countries, the procyclical behavior of spending in good times is taken to be a “stylized fact” (European Commission, 2001; Buti, Franco, and Ongena, 1998; and Buti and Sapir, 1998). The empirical evidence, however, is not consistent, with some studies finding procyclicality while others show zero or negative effect. In contrast, the literature on comovements between public expenditures and GDP growth in emerging market and developing countries consistently suggests that expenditures are procyclical (see Akitoby and others, 2004).

More recent estimates also corroborate the existing evidence on the cyclicality of expenditure. In industrial countries, in response to a 1 percentage point widening in the negative output gap, the expenditure ratio increases by 0.4 percentage point. When the output gap is positive, however, there is no symmetric decrease in the ratio following an increase in the output gap. In emerging market countries and developing countries, due to data limitations, the evidence is more tentative. It nevertheless suggests that the ratio of expenditures to GDP tends to increase in good times.

Causes of Procyclicality

A variety of economic, financial, and political economy factors can lead to fiscal policy being procyclical and asymmetric. These include the well-identified lags in the formulation and implementation of policy, political economy and institutional considerations, and factors related to the availability of financing. These factors can reinforce each other. It has been suggested, for instance, that procyclical fiscal policy in many Latin American countries has been part of a vicious cycle, in which political factors preventing savings in upturns limited creditworthiness in bad times and made fiscal consolidation during recessions unavoidable.

Difficulties in Assessing the Economic Cycle

One explanation of procyclicality stems from the premise that, while the government has the means to engage in countercyclical policy, it ends up not doing so because of an inaccurate assessment of the economic cycle. The presumption is that the policymakers are unable to gauge accurately the stage of the cycle: there may be difficulties in estimating the underlying or potential growth of the economy; there may be problems regarding the assessment of the output gap and the economy’s momentum; and there may be substantial lags in the availability of data. These difficulties are then compounded by lags in the implementation of policy.

The problems of estimating the underlying potential of the economy are likely to be particularly acute in emerging market and developing countries. These economies are subject to substantial and frequent shocks, for both endogenous and exogenous reasons. With regard to the former, many of the economies have embarked on major reforms that can change the structural characteristics and performance of the economy, making it difficult to assess whether buoyant activity reflects temporary or permanent factors. The exogenous factors can be equally important: exports are often concentrated in a relatively small number of sectors and a sustained shock in the terms of trade can have a significant impact. Furthermore, as emerging market crises over the past decade highlight, these economies have also been prone to sudden shifts in market sentiment.

Even in the case of industrial countries, there are many instances where the economic turning points were inaccurately assessed and policy ended up being procyclical. In the face of significant changes emanating from the introduction of new technologies, globalization, and financial market innovation, it is difficult to assess the cyclical status of even major economies, and delineate, ex ante, turning points accurately. These difficulties have been compounded by the impact of sharp changes in asset prices on consumption, as well as on investment and on the overall pace of activity (see, e.g., IMF, 2004).

While the above considerations are important in many cases, it is unclear whether they can provide a general explanation for procyclicality. Decision and implementation lags can certainly play a role in leading to policy procyclicality. But this cannot be the sole explanation given the above evidence that procyclicality tends to be asymmetric. Moreover, the evidence of systematic bias toward optimism in official forecasts of output growth is at odds with the notion of procyclicality arising from inadequate information about the state of the cycle (Danninger, Cangiano, and Kyobe, 2005).

Political Economy Factors

A second explanation, based on the interaction between budgetary decisions and political economy factors, emphasizes the dynamics of spending pressures arising in good times. The evidence concerning the asymmetry of procyclicality and the role played by expenditure suggest that political economy factors often play a key role in shaping the cyclicality of fiscal policy.2 The roots of this lie in policy discretion, and the importance of competing electoral constituencies. Indeed, as Buchanan and Wagner (1977) noted, political pressures lead to stimulative policies regardless of the economic environment. A key argument is that constituencies and lobbies compete for their share of public resources, and a “common pool” problem arises. The good times whet the appetites of various powerful groups with access to government resources. The incentives for fiscal prudence are low because even if specific interest groups do not push for a larger share of spending for themselves, they will still have to suffer the consequences of overspending: since budgetary competition increases in good times, spending grows more than proportionally relative to the increase in revenue (Lane and Tornell, 1999).

Political economy factors reflect the role of checks and balances. There is evidence that political constraints can help reduce the common pool problem, and hence procyclicality. This is in part because political constraints, including, for instance, the executive’s veto power on expenditures, can limit the scope for discretionary policy changes. Conversely, a lack of veto power may be expected to be associated with more volatile spending—particularly high spending during boom times, and a sharp retrenchment during downturns. Political constraints based on the number of veto points among various branches of government, as well as on the ideological alignment across branches, are seen to explain considerable variation in policy volatility (Fatás and Mihov, 2004).

Countries with good institutions tend to have countercyclical policies in good times. Good institutions—defined in terms of the quality of bureaucracy, rule of law, absence of corruption, and democratic accountability—allow policymakers to use windfalls in good times to build up cushions of reserves for the inevitable downturn. In the process, they also help stabilize the economy. On the other hand, in countries with weak institutions, the competition for the “common pool” resources leads to a dissipation of the windfalls during good times. Changes in fiscal policy made by governments seeking reelections can be an augmenting factor. However, unless the electoral and business cycles are synchronized, vote seeking cannot explain systematic procyclicality.

Exuberant spending in good times may exacerbate the debt situation, necessitating procyclical correction in the downturn. This effect can be compounded by rigid fiscal rules. For instance, if inadequate attention is paid to building safety margins in good times, balanced budget rules may lead procyclical discretionary action to offset the automatic stabilizers during the ensuing downturn. However, in practice, balanced budget rules are seldom binding. When they are especially tight there are usually escape clauses. In any case, the responsibility lies with policy, rather than with the rules. If policy leads to excessive debt levels, a procyclical correction in downturns may be necessary, independently of what fiscal rules prescribe. This phenomenon has been observed in both developing and industrial countries. In the latter, with specific reference to the European countries, frequent procyclical tightening has been noted over 1970–2000 (European Commission, 2001), and there is little evidence that the introduction of a nominal deficit ceiling with the 1992 Maastricht Treaty changed this preexisting pattern (Galí and Perotti, 2003; and Balassone and Francese, 2004).

Financial Constraints and Market Access

A third explanation is related to financial constraints and the limits on access to international capital markets. The precarious nature of access to international financial markets during downturns, particularly by emerging market economies, provides an important explanation as to why discretionary policy is not countercyclical during recessions.3 There is significant evidence that external funding weakens when it is most needed to finance countercyclical policy. The investors’ loss of confidence in the prospects of these economies means that oftentimes in the midst of recessions countries end up having to implement strongly contractionary policies. This can then create a vicious cycle by deepening the recession, reducing tax revenues further, and warranting further expenditure cuts. Such response, although destabilizing, may be the only way to service existing obligations and signal the government’s commitment to deal with unsustainable policies.

Restricted financing in bad times may also reflect capital market imperfections. Even where the budgetary situation is sustainable, the inability to borrow contingent on the economic situation constrains the options available to policymakers and reduces the economy’s flexibility. This is particularly so given the higher propensity of emerging market countries to be subject to exogenous shocks. Moreover, the ensuing uncertainty regarding the duration of the boom and the associated revenue windfalls impels competing constituencies to push for higher spending in an upturn, rather than building up buffers for the downturn, raising the need to borrow during the period of weak activity (Emre and Kumar, 2005).

The impact of financial constraints is exacerbated in bad times if economies are characterized by high public debt. During a sharp downturn, the underlying fiscal adjustment needed to stabilize debt dynamics can be so large as to raise doubts about the government’s ability to undertake it. This can adversely affect sentiment, prompting investors to sell assets indiscriminately at the onset of a decline in activity, compounding the absence of fresh financing. This underlies the evidence that in these economies the capital flow cycle and the policy cycle reinforce each other (Kaminsky, Reinhart, and Vegh, 2004).

The currency composition of debt is also an important factor leading to procyclicality in emerging market and developing countries. Since until recently almost all external borrowing by emerging market countries has been in foreign currency, the external debt service payments and the budgetary situation in these countries are affected by movements in the exchange rate. The volatility in the latter is often greater than volatility in output, particularly during bad times (Eichengreen and Hausmann, 2005). The effect of exchange rate on debt servicing is muted for industrial countries that can borrow in domestic currency. By contrast, in emerging market countries exchange rate depreciation can significantly increase the debt-to-GDP ratio and the interest burden on that debt.

The term structure of debt is also relevant. Whether borrowing in foreign or in domestic currency, the maturity of outstanding debt in emerging market countries tends to be weighed toward the short term. This means that movements in the real interest rates, often quite marked, have a substantial impact on debt service. Unlike in most industrial countries, real interest rates in emerging market countries, reflecting in part higher risk premia, are often inversely related to the business cycle. Thus the burden of servicing the debt is least when resources are plentiful, and onerous when they are not.

The combination of movements in real exchange rates and real interest rates with the economic cycle can exacerbate the impact of debt on procyclicality. In bad times, both the exchange rate depreciates and interest rates rise, tending to increase debt and debt service payments. This in turn further increases the borrowing requirement at a time when the availability of finance is most constrained, resulting in procyclicality of policy.

Consequences of Procyclicality

Procyclicality and Growth

Procyclical fiscal policy exacerbates economic fluctuations. In both industrial and developing economies there is evidence that by boosting activity in upturns and failing to sustain it or even injecting a contractionary impulse in downturns, procyclical policy increases the amplitude of the economic cycle. A significant link between policy volatility and macroeconomic instability has been highlighted in a number of studies. In particular, estimates suggest that a 1 percent reduction in policy volatility (defined as the standard deviation of cyclically adjusted government spending) leads to a decline in output volatility of a similar magnitude (Fatás and Mihov, 2003). There is particularly striking evidence that in Latin America procyclicality of fiscal policy has contributed to output volatility. Taking as a benchmark industrial and East Asian countries, it is estimated that about 15 percent of the excess output volatility in Latin American countries has been due to volatility in fiscal policies (De Ferranti and others, 2000). Output volatility reinforces volatility in government revenues, which during the 1990s was four times higher in developing than in industrial countries (Eichengreen and Hausmann, 2005).

Output volatility has significant short-term adverse effects that are especially marked in developing countries. In these countries, social insurance mechanisms, such as unemployment benefits, are less developed than in the industrial countries. Moreover, income distribution is often such that those in the low- and middle-income brackets are at greater risk of falling into poverty if hit by a shock (Braun and Di Gresia, 2003). In addition, the low-income groups have less human capital to adapt to downturns in labor markets, and fewer physical assets and access to credit to allow them to tide over adverse times.

These effects can also have long-term welfare implications. Poverty levels appear to increase sharply in steep downturns in economic activity and do not recede to previous levels as output recovers (World Bank, 2000). Recent empirical research confirms that volatility has a significantly negative impact on poverty (Laursen and Mahajan, 2005). Further, there is evidence that there may be irreversible losses in health and education because of inadequate nutrition and schooling (Perry, 2003). The inability of governments to support economic activity in a downturn, in large part because of the absence of cushions built up during good times, can thus have broad and sustained welfare consequences for low-income groups in developing economies.

It is difficult to obtain from economic theory unambiguous indications regarding the impact of volatility on output growth. Some models suggest that volatility may not worsen growth, reflecting the notion that it may be associated with the adoption of riskier technologies that are also characterized by higher expected returns and, therefore, higher growth (see, e.g., Black, 1987). A positive relationship between volatility and growth may also result from Schumpeterian “creative destruction” (Caballero and Hammour, 1994). However, a considerable literature suggests that by increasing uncertainty, high volatility, whether from procyclical policies or other sources, adversely affects investment and growth. To the extent that investment decisions are costly to reverse, higher volatility can increase risk and risk aversion, thereby discouraging new investment (Bernanke, 1983). In a volatile environment short-run considerations are also likely to be given greater weight and could lead to suboptimal allocation of resources to investment (Servén, 1998). In addition, excess volatility can cause irreversible losses in human capital—including through the effect of more frequent spells of unemployment on learning-by-doing opportunities—compounding the negative effect on growth (Martin and Rogers, 1997).

Most empirical studies find an inverse relationship between volatility and growth. This is so for both industrial and developing economies, with particularly clear evidence accumulated in recent years (IMF, 2005; and Aizenman and Pinto, 2005). It has been estimated that a 1 percent increase in output volatility (as measured by the standard deviation of output growth) can lower economic growth by about the same amount (Kose, Prasad, and Terrones, 2005). Specifically, volatility associated with discretionary fiscal policy has been seen to distort savings and investment decisions with adverse effects on economic growth.

The relationship between volatility and growth also depends on country-specific characteristics and on the source of volatility. Developing countries with weaker institutions and less mature financial markets are likely to be more affected. Market imperfections associated with credit constraints and imperfect access to world financial markets can magnify the negative impact of short-term volatility on the pace of activity, exacerbating the amplitude of the cycle. Periods of high volatility associated with financial crises seem to have a more harmful and prolonged effect on economic growth than volatility stemming from normal macroeconomic fluctuations (IMF, 2005).

Procyclicality and Sustainability

The asymmetric reaction of fiscal balances to positive and negative cyclical conditions has an adverse effect on debt dynamics. Assuming that economic fluctuations are broadly symmetric, this simply reflects the fact that deficits incurred in downturns are not compensated for by surpluses during the rebound in economic activity. Estimates by IMF staff indicate that, over the 1980s and 1990s, average deficit-to-GDP ratios would have been 30 percent lower in industrial countries and almost 50 percent lower in emerging market and developing economies if policy had been symmetric over the economic cycle (Figure 3.2).

The average contribution of cyclical asymmetry in fiscal policy to debt accumulation is significant. In industrial countries it has been estimated to be about 8 percentage points of GDP over 1970–2000, about one-third of the average increase in debt ratios over the same period (Balassone and Francese, 2004). The degree of asymmetry estimated for emerging market and developing countries suggests a similar contribution to debt accumulation. Simulations for individual countries for the past two decades suggest that the debt-to-GDP ratio would have been up to 10 percentage points lower had policy been symmetric.

Figure 3.2.Difference in Average Deficit Under Symmetric and Asymmetric Fiscal Policy 1

Source: IMF staff calculations.

1 Average deficit under asymmetric policy = 100. For details on the sample and estimation, see footnotes to Table 3.1.

Hence, procyclicality and asymmetry can damage fiscal sustainability by negatively affecting both debt and output growth. The extent to which the path under asymmetric policy departs from the symmetric one is illustrated in Figure 3.3. The dotted line depicts the debt-to-GDP ratio under symmetric countercyclical policy (budgetary elasticity is assumed to be 0.5) for a country with an initial debt-to-GDP ratio of 30 percent (it is assumed that the economic cycle is of eight years, during which output gap is positive (2 percent) in the first four years and negative (−2 percent) in the subsequent four (around a constant potential output)). In this scenario, the debt ratio fluctuates close to its original value. The segmented line shows that when policy becomes asymmetric an upward bias is introduced in debt accumulation. In the figure it is assumed that asymmetry results from the budget balance not reacting to positive output gaps. Over a period of 20 years, the debt-to-GDP ratio increases by 10 percentage points of GDP. Finally, the solid line depicts the evolution of the debt ratio under the assumption that procyclicality also lowers GDP: this further raises the debt ratio, especially in the outer years.

Figure 3.3.Procyclical Asymmetry in Fiscal Policy and Debt Dynamics

Source: IMF staff calculations.

Conclusions

This chapter has analyzed a number of issues relating to the procyclicality of fiscal policies in industrial and developing countries, and provided systematic empirical evidence. The main findings are as follows:

  • There is clear evidence that discretionary fiscal policy tends to be procyclical in both industrial and developing countries, offsetting the impact of automatic stabilizers, particularly in good times. Policy tends to be acyclical or mildly countercyclical in bad times, although there is evidence that for many emerging market countries in particular, policy is procyclical in bad times as well.
  • The evidence is consistent with the notion that in the boom phase of an economic cycle, buoyant revenues are accompanied, often for political economy reasons, by an even greater exuberance in government expenditures. Procyclicality may also reflect an inaccurate assessment of the cycle, as well as financial market constraints, particularly for emerging market countries in the downturn.
  • Procyclical fiscal policy exacerbates economic fluctuations, which in turn has near-term adverse effects on welfare that are especially marked for low-income groups in developing countries. Economic volatility also has adverse effects on savings, investment, and economic growth. Furthermore, since the procyclical bias appears to be stronger in the upturn, deficits and debt built up during bad times are in general not offset, and in many cases are in fact added to, during good times, with the result that the fiscal position deteriorates over time.
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1

The output gap is defined in the conventional manner: (actual output - potential output) / potential output.

3

On investors’ shifting risk appetite, see Kumar and Persaud (2002).

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