The Impact of Economic Policy on the Business Cycle: Theoretical Model and Empirical Evidence from the U.S.

The objective of this paper is to determine whether economic policy can increase GDP volatility. The authors try to assess, more particularly, if the actions of the monetary authority following a negative tax shock could amplify the business cycle. The starting point is a balanced GDP growth path in a neoclassical growth model to which is added an income tax. This tax rate will reduce output and thus, in the presence of wage rigidities, will lead to an increase in unemployment. The authors show that if the Central Bank implements an expansionary monetary policy to try and curb unemployment by boosting output, this policy mix could originate (or at least amplify) the business cycle. The relationship between GDP volatility and economic policy is then tested in the United States over the 1980-2010 period. The authors show that, in accordance with the theoretical model, economic policy contributed to increase GDP volatility in the US between 1980 and 2010.

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