This paper offers a further development of existing macro-economic models enabling researchers to establish the impact of government size (expenditures, transfers or taxes) on the volatility of the business cycle. Understanding these effects has important implications for the design of stabilizing fiscal policies.
Javier Andrés and Rafael Doménech (both from the University of Valencia) and Antonio Fatás, Professor of Economics at INSEAD, suggest alternative models of the business cycle, which replicate the stylized fact that large governments are associated with less volatile economies. They compare the predictions of a frictionless model of the business cycle to those of models that incorporate nominal rigidities, costs of adjustment for capital and rule-of-thumb consumers.
Understanding the exact mechanisms through which fiscal policy interacts with the business cycle is necessary for governments and economic advisers to better assess the potential consequences of budget decisions on economic variables and financial markets.