The Impact of Fiscal Policy Convergence on Business Cycle Synchronization between Croatia and Eurozone Countries - Panel Analysis

Abstract

This paper analyzes how fiscal policy convergence impacts the business cycle synchronization between Croatia and eurozone countries and consequently indirectly affects the costs of monetary integration using panel data analysis. The main aim of the paper is to create a methodological framework for an empirical model based on critical examination of previous research.

In the empirical model the dependent variable is business cycle synchronization, and the main independent variable is fiscal policy convergence. The problem of simultaneity (reverse causality) between dependent and independent variable is solved by using cyclically adjusted budgetary balance as indicator of discretionary fiscal policy. For control variables in the model we applied determinants of business cycle synchronization often used in this kind of research - financial integration, trade integration and sectoral structure similarity.

Parameter estimation is performed using the fixed effects panel model. Our dataset involves Croatia and  the eurozone countries and includes bilateral observations from 2001 to 2016. Unlike similar research which performed mostly cross-sectional analysis, this paper includes the time dimension and puts Croatia in the focus of research which has not been done before. Also, the paper contributes to research methodologically by estimating business cycles using the production function method and by measuring business cycle synchronization by using Cerqueira-Martins index. The results confirm that business cycle synchronization is positively influenced by fiscal policy convergence which indicates the necessity to comply with the rules proposed by the Stability and growth pact. It is also suggested that small open economies in process of accession, which is the case of Croatia, need to employ anticyclical  discretionary fiscal policy.