Cyclicality of Fiscal Policy: Permanent and Transitory Shocks

This paper examines the optimal reaction of fiscal policy to permanent and transitory shocks to output in a model of tax and public consumption smoothing. The model predicts that optimal reaction of public expenditures and deficits to transitory shocks should be countercyclical, while optimal reaction to permanent shocks should be a-cyclical. Using the Blanchard and Quah (1989) methodology for identifying permanent and transitory shocks, we test these predictions for a sample of 22 OECD countries over the years 1963-2006. We find that both expenditures and deficits are countercyclical to transitory shocks, mainly through public transfers and mainly in recessions. We find that government investment is pro-cyclical with respect to permanent shocks, but total expenditures are not.