Pakistan Institute of Development Economics



Macroeconomic Policies and Business Cycle: The Role of Institutions in Selected SAARC Countries

Fiscal and monetary policies are used to smooth the cyclical fluctuations in output. There is ample evidence that developed countries use counter cyclical policies in principle for this purpose [Gali and Perotti (2002); Sack and Wieland (2007)]. Indeed, OECD and other developed countries use loose monetary and fiscal policies to tackle with financial crisis of 2007 [IMF (2008)]. However situation is reverse in developing countries, they are using the pro-cyclical policies to stabilise business cycle fluctuations that results in higher output volatility [Hausmann and Stein (1996); and Kaminsky, Reinhart, and Vegh (2004)]. Theoretically, there are several factors such as limited excess to credit, poor governance and institutions1 that are responsible for conduct of pro-cyclical policies in developing countries, of which institutional framework is important. A poor institution is a key factor that is responsible for the conduct of pro-cyclical policies in emerging market economies. Countries, where institutions are strong, conduct contractionary policies in boom and expansionary policies in recession while countries with poor level of institutions contract the policies in recession and expand in boom [Acemoglu, Johnson, Robinson, and Thaicharoen (2003); Calderon and Schmidt-Hebbel (2008)]. Countries with weak institutions show the strong negative relation between output and interest rate while countries with strong institutions have positive link between output and interest rate [Duncan (2012)]. That’s why developing countries are pursuing tight monetary policy in recession and loose policy in boom, although little empirical literature is available on this issue [Lane (2003)]. Fiscal policies are pro-cyclical in the countries, where political system is subject to multiple fiscal veto points that results in higher output fluctuation [Stein, et al. (1999); Braun (2001)]. Indeed, rent-seeking government conducts pro-cyclical policies.