Boom–bust cycles and procyclical fiscal policy in a small open economy

The PIGS countries have suffered economic instability and fiscal havoc in the aftermath of the Financial Crisis. We argue this is the consequence of pursuing procyclical fiscal policies. We add a fiscal rule, which varies public spending with the cycle, to an otherwise standard RBC model of a small open economy. This procyclical reaction of fiscal policy to output distorts intertemporal allocation decisions. Procyclical spending generates very volatile cycles in investment and the current account. Our model is able to replicate the relationship between the degree of cyclicality of fiscal policy and the volatility of consumption, investment and the current account we observe in OECD countries. A policy that let automatic stabilisers work can effectively smooth economic fluctuations, especially after structural reforms that raise the responsiveness of the economy.