This paper is motivated by an empirical observation which appears, on the surface, to be counter—intuitive: the evidence of pro-cyclical fiscal behavior noted in a variety of studies (for examples, see Talvi and Végh (1996) for Latin America, Thornton (2008) for Africa, Lane (2003) for the OECD, and Ilzetski and Végh (2008) for developing countries). These studies point to the prevalence of pro-cyclical behavior. One could perhaps rationalize the procyclical behavior over the course of a normal cycle as follows: when economic times are good, citizens expect a dividend in terms of higher spending in the form of more and better entitlement programs and when times are bad, they understand the inevitable belt-tightening that must take place. But, a stronger case can be made for counter-cyclical government spending behavior. Pro-cyclical government spending in the expansionary phase of the business cycle could exacerbate inflationary pressures, while pro-cyclical government spending policy during the contractionary phase of the business cycle could be welfare-reducing. In contrast, counter-cyclical fiscal behavior during boom (bust) times could serve as a stabilizing influence on the economy. Why then do we observe pro-cyclical fiscal behavior?

The aim of the paper is to examine whether a case—such as reducing income inequality—can be made to support pro-cyclical fiscal policy, especially for small open economies. The decision to work with an open rather than closed economy model reflects the importance of global shocks. This paper assesses the implications of cyclical fiscal spending policy for the case of a productivity shock, a domestic interest rate shock as well as for the case of external shocks coming from export demand and the terms of trade.