Agency costs, fiscal policy, and business cycle fluctuations

Abstract

This paper studies the relationship between scal policy, nancial market frictions and business cycle uctuations. It is shown that in an economy where balance sheets play a role in the propagation of shocks, using countercyclical scal policy net worth and output uctuations can be reduced. This countercyclical scal policy requires to distribute resources to the entrepreneurs when a negative technology shock is realized and levy taxes on entrepreneurs after the technology shock is back to zero. It is shown that after the realization of a negative shock, countercyclical scal policy reduces agency costs which would make entrepreneurs increase investment and dampen the business cycle uctuations via decreasing uctuations in net worth. By this increase in investment, nancial fragility decreases, which reduces the slowdown of economic activity.