Working Paper: CEPR ID: DP4372
Authors: Antonio Fatas; Ilian Mihov
Abstract: Fiscal policy restrictions are often criticized for limiting the ability of governments to react to business cycle fluctuations. Therefore, the adoption of quantitative restrictions is viewed as inevitably leading to increased macroeconomic volatility. In this Paper we use data from 48 US states to investigate how budget rules affect fiscal policy outcomes. Our key findings are that (1) strict budgetary restrictions lead to lower policy volatility (i.e. less discretion in conducting fiscal policy); and (2) fiscal restrictions reduce the responsiveness of fiscal policy to output shocks and decrease the persistence of spending fluctuations. These two results should have opposite effects on output volatility. While less discretion should reduce volatility, less responsiveness of fiscal policy might amplify business cycle volatility. Our analysis shows that the first effect dominates and that restrictions on fiscal policy lead to less volatility in output.
Keywords: business cycles; fiscal policy; fiscal rules
JEL Codes: E32; H30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Strict budgetary restrictions (H61) | Lower policy volatility (E63) |
| Fiscal restrictions (E62) | Reduced responsiveness of fiscal policy to output shocks (E62) |
| Strict budgetary restrictions (H61) | Decrease in elasticity of fiscal policy with respect to output fluctuations (H31) |
| Less discretion in fiscal policy (E62) | Reduced volatility (G19) |
| Reduced responsiveness of fiscal policy (E62) | Increased business cycle volatility (E32) |
| Strict budgetary restrictions (H61) | Less overall volatility in output (E39) |