Stochastic trends and fiscal policy

Abstract

We study empirically the reaction of fiscal policy to changes in the permanent and transitory components of GDP in a panel of countries. We find evidence that government spending tends to be counter-cyclical conditional on temporary shocks and pro-cyclical conditional on permanent shocks. We also find no evidence that developing countries are systematically different from developed ones in terms of fiscal policy. We propose an extended dynamic and stochastic RBC model assuming a fiscal reaction function to the output gap and a measure of debt sustainability. The fiscal impulse response to a permanent (temporary) shock is positive (negative) as the effect on debt sustainability (current output gap) dominates.