Fiscal Rules, Discretionary Fiscal Policy and Macroeconomic Stability: An Empirical Assessment for OECD Countries

Abstract

Does aggressive use of discretionary fiscal policy induce macroeconomic instability in terms of higher output and inflation volatility? Three main conclusions arise from our cross-section and panel analysis for a sample of 20 OECD countries: First, discretionary fiscal policy has a significant and sizeable effect on volatility of GDP (per capita) and all of its components. Second, there is no direct effect on inflation volatility; since output volatility is an important determinant of inflation volatility, however, discretionary fiscal policy indirectly exacerbates inflation volatility. These results turn out robust with respect to alternative fiscal policy measures and endogeneity concerns. Finally, many of the fiscal rules introduced since 1990 appear to have reduced the use of discretionary fiscal policy.