Fiscal Policy over the Real Business Cycle: A Positive Theory
with Levon Barseghyan and Stephen Coate
This paper develops and assesses the implications of the political economy model of Battaglini and Coate (2008) for the behavior of fiscal policy over the business cycle. The model predicts that fiscal policy is counter-cyclical with debt increasing in recessions and decreasing in booms. Public spending increases in booms and decreases during recessions, while tax rates decrease during booms and increase in recessions. In both booms and recessions, fiscal policies are set so that the marginal cost of public funds obeys a submartingale. The quantitative implications of the model are assessed by calibrating the model to the U.S. economy using data from 1979 to 2009. Despite its parsimonious structure, the model matches well the empirical distribution of debt and also its high volatility, strong persistence, and negative correlation with output. Consistent with the data, the model implies that public spending and tax rates are persistent and not very volatile.