Fiscal fragility and business cycles in Brazil after the Real Plan: Evidence from a dynamic factor model applied to VAR analysis

Abstract

Fiscal policy interventions are frequently prescribed to attenuate fluctuations in economic activity. Reliance on fiscal initiatives is particularly recommended during severe recessions when monetary policy has limited efficacy. Nevertheless, empirical evidence from emerging economies indicates that public expenditures frequently exhibit a procyclical behavior, and fiscal imbalances may trigger economic crises. This paper applies a dynamic factor model to derive an index of the public sector financial fragility and estimates vector autoregressions (VAR) to investigate the cyclical behavior of fiscal policy in Brazil. Using monthly data from 1996 to 2019, the empirical analysis verified if fiscal fragility grows as the country’s economic activity expands. The results show that fiscal fragility apparently declines after positive exogenous shocks in production and other factors that contribute to macroeconomic instability lead to greater fiscal imbalances, such as increases in exchange rate volatility.