Financial development, financial instability, and fiscal policy volatility: International evidence

Abstract

This paper investigates the effects of financial development and financial instability on fiscal policy volatility using system GMM estimator based on panel data of 96 countries from 1990 to 2019. We find that higher levels of financial development are associated with lower fiscal policy volatility, but an increase in financial instability would lead to greater volatility in fiscal policy. We also find that the harmful effect of financial instability on fiscal policy conduct would be alleviated in the normal phase of the financial cycle but would be magnified during expansionary, recessionary and crisis periods. This paper extends the existing literature by highlighting the role of finance in fiscal policy volatility, where a large and stable financial system is conducive to the smooth conduct of fiscal policy.