Essays on Business Cycles and the Causes and Consequences of Procyclical Policies

The conventional wisdom regarding the cyclical behavior of macroeconomic policy is that both fiscal and monetary policies are countercyclical or acyclical in most advanced economies, but procyclical in many emerging and developing countries. Procyclical policies are conducted by fiscal authorities cutting (raising) budget deficits and by the monetary authorities raising (cutting) interest rates during recessions (booms). Such policies are deemed sub-optimal since they will tend to reinforce the cyclical fluctuations, aggravating the busts and exacerbating the booms. These characteristics have sparked a debate on how to achieve policy discipline to boost macroeconomic performance. Motivated by this debate, the main purpose of this thesis is to evaluate the core determinants of procyclical policies and to assess their consequences on macroeconomic performance. In Chapter 2, by using data from 137 countries for 1970-2014, we show that fiscal procyclicality has become the norm rather than the exception in many countries. More specifically, over the last 45 years, a substantial number of emerging and low-income developing countries are trapped within procyclical policy, in the sense of not being able to move from procyclical to countercyclical fiscal policy. We also show that even after controlling for the endogeneity of “government quality” and other determinants of procyclicality, there is a causal relation running from better “government quality” to more countercyclical or less procyclical policy. We then focus on the cyclical properties of monetary policy in Chapter 3. We find that many countries, specifically emerging and low-income developing countries have also faced challenges in implementing countercyclical monetary policies. We document that over the last 55 years, a large number of countries consistently followed procyclical monetary policy or have recently turned procyclical. We then aim to address the question, why this has been the case. We show that procyclical stop-and-go policies are intensified in the presence of “fear of free floating”, that is, monetary authorities’ reluctance to avoid large swings in the exchange rates. We also find that our results are robust to the endogeneity of “fear of free floating” and other determinants of procyclical monetary policy. In Chapter 4, we explore whether procyclical macroeconomic policy stances – being contractionary in bad times and expansionary in good times – have consequences for the rest of the economy. We provide empirical evidence that observed procyclical fiscal and monetary policy have significant macroeconomic costs; procyclical countries have lower rates of economic growth, higher rates of output volatility and inflation volatility. In Chapter 2 and 3, we also show that over the last decades some emerging countries have been able to escape the procyclicality trap and become countercyclical. During the global financial crisis 2008-09, these countries pursued countercyclical macroeconomic policy to counter the sharp drop in economic activity. However, our cross-country evidence in Chapter 5 provides little evidence for a central role of countercyclical policy to cushion against the global financial shock. We find that pre-crisis level of short-term external debt and collapse in export demand were the key factors determining the intensity of 2008-09 crisis