Government size, inflation targeting and business cycle volatility

Abstract

In this paper I analyze how government size used as a proxy for fiscal stabilization policy and inflation targeting influence the amplitude of the business cycle and private consumption volatility in a sample of developing countries, for the period between 1990 and 2018. Taking into account the potential endogeneity of these variables, and controlling for the exogenous variation in trade openness, the analysis provides strong evidence that government size significantly reduces business cycle volatility while it exerts no significant impact on private consumption volatility. On the other hand, adopting inflation targeting significantly increases the amplitude of the volatility of real output growth, while significantly decreasing private consumption volatility. The implemented form of the inflation targeting regime does not introduce any significant changes in the obtained results. The findings seem to provide evidence that there is a potential for an improved coordination between fiscal and monetary policy actions in developing countries that have adopted inflation targeting.