Inequality, fiscal policy, and business cycle anomalies in emerging markets

Government expenditures are procyclical in emerging markets and countercyclical in developed economies. We show this pattern is driven by differences in social transfers: transfers are more countercyclical and make up a larger portion of spending in developed economies. We use a small open economy model to study how much these differences in fiscal policies can account for differences in business cycle characteristics of emerging economies, particularly excess volatility of private consumption. We find that ignoring disparate fiscal policy results in an overestimation of the persistence of technology shocks in emerging markets relative to developed by 52%. We study how this conclusion depends on differences in the extent and sources of inequality across countries.