creates a need for borrowing by firms for working capital and leads to countercyclicality of factors demand and output. If these effects are more pronounced in smaller economies, the effects of interest rate shocks will be more important for them, relative to larger economies.

The procyclicality of fiscal policy in developing countries, as opposed to countercyclical or acyclical fiscal policy in developed countries, has also been highlighted in the literature. Gavin and Perotti (1997) showed that this is the case in Latin America, while Talvi and Végh (2005) and Ilzetzki and Vegh (2008) extended this finding to the entire developing world. Recently, the fiscal stance in developing countries has been changing. For instance, Frankel, Vegh, and Vuletin (2013) showed that many developing countries are moving away from pro-cyclicality, although it still remains predominantly pro-cyclical. Carneiro and Garrido (2015) evaluate this claim in a larger sample of countries, for various sub-periods and stages of the business cycle, as well as using a variety of de-trending methods and generally confirm it. Hnatkovska and Koehler-Geib (2016) using simple unconditional correlations, evaluate the cyclicality of fiscal consumption, investment, revenues and expenditures in small and large countries, and find that smaller countries have significantly more procyclical public revenues and fiscal balance compared to large economies. One shortcoming of their analysis is that an unconditional correlation compounds the endogenous feedback effects between fiscal policy and economic conditions of the country. In this paper, we revisit the evidence on fiscal policy cyclicality in small and large economies by means of a VAR analysis, which allows us to estimate the effects of government expenditure shocks on GDP and other key macroeconomic aggregates. Such an analysis is particularly relevant in small economies, given their lack of economies of scale and larger size of the government sector.

Among external drivers of business cycle fluctuations, we consider the world real interest rate shocks and shocks to foreign demand. To capture the foreign demand conditions, we would have liked to use the trade-weighted real GDP of the key trade partners for each country. However, these data are not available for most of the countries. Instead we chose to proxy for the world demand conditions using real GDP in the United States obtained from the Bureau of Economic Analysis (BEA).

The existing literature also emphasized that world interest rate is an important factor driving business cycle fluctuations in developed and developing countries. Lubik and Teo (2005) using an estimated model of small open economy show that world interest rate can account for over 40% of business cycle fluctuations in developing countries. Neumeyer and Perri (2005) in a representative emerging economy find a number that is around 30%. Uribe and Yue (2006) using a panel of emerging market economies reports that about 20% of aggregated fluctuations can be attributed to the world interest rate shocks. This contribution is estimated to be significant in developed economies as well. For instance, Blankenau, Kose and Yi (2001) find that world interest rate shocks account for about 30% of business cycle volatility in Canada. Therefore, to account for the effects of world interest rates shocks on the economies in our sample, we include the real 3-month US T-bill rate in our estimation. The latter is obtained as the difference between nominal 3-month US T-bill rate and annualized CPI inflation rate, both from the BEA.

For a few countries, for which the data are available, we also consider shocks to the terms of trade. Fluctuations in the terms of trade have historically been viewed as an important source of 6