interest rate is measured as the lending rate, whenever available. In the subset of countries where lending rate was not available, we used the deposit rate or the money market rate. If those were not available, we used the discount rate or the T-bill rate. In our analysis we focus on the real interest rate computed as the difference between the nominal interest rate and the annualized consumer price index (CPI) inflation rate. Terms of trade is computed as the ratio of export unit value to import unit value, so that ���� � ������ , where ��� is the unit value of exports and ��� is the unit value of imports. Unfortunately, terms of trade is not available for the majority of the countries in our data set, so in our benchmark analysis we omit it. Real exchange rate is the real effective exchange rate which is a measure of the value of a country's currency against an inflation-adjusted and trade-weighted index of foreign currencies. Thus, an increase in the real exchange rate implies an appreciation.

Next, to control for the potential effects of governance, political, economic and financial risk, and political conditions on the business cycles characteristics and sources of volatility, we use the _International Country Risk Guide_ (ICRG) database. This data covers the period going back to 1984.

Lastly, to assess the effects of fiscal rules on the sources of volatility we rely on the International Monetary Fund’s _Fiscal Rules database_ which contains information on the type of fiscal rule in place, year of implementation, monitoring and enforcement procedures used. This data set is at annual frequency and covers 1985-2014 period.

# **3. Literature and Methodology**

Our methodological approach relies on multivariate time-series analysis. We start by providing a comprehensive account of volatility of the key macroeconomic aggregates in each country in our sample using a vector autoregression (VAR) model estimated country by country. To assess the role played by various internal and external shocks in each individual country we employ the Forecast Error Variance Decomposition (FEVDC) and Impulse Response Function (IRF) techniques. To contrast the sources of volatility in small and large, developed and developing, high risk and low risk, with and without fiscal rules countries, we report the results separately for these groups.

Among domestic variables influencing business cycles we consider technology (productivity) shocks, shocks to trade balance and the real exchange rate, as well as variables that capture the stance of policy. In terms of the latter, we focus on two key variables: domestic real interest rate and government expenditures. The inclusion of policy variables reflects the possibility that government policies in smaller and developing countries often exacerbate business cycle fluctuations.

For instance, a large literature has documented that interest rates tend to be countercyclical in developing countries, while they tend to be procyclical in developed economies (see Neumeyer and Perri (2005), Uribe and Yue (2006) and others). The typical explanations for this cyclical behavior of real interest rates is the presence of financial frictions, such as the requirement that firms have to pay for part or all of the factors of production before production takes place. This 5