types of fiscal rules and non-adopters. We find that volatilities of almost all variables are lower for countries with fiscal rules in place. However, after controlling for country size and other country characteristics, the difference remains highly statistically significant for inflation only. Interestingly, this result masks significant differences in business cycle characteristics of countries with different types of fiscal rules. For instance, we show that lower volatility result was driven by countries with revenue rules.

We then subject our findings to a series of robustness checks. First, we contrast the length and amplitude of business cycles in small and large countries. For this purpose, we apply the Harding and Pagan (2002) business cycles dating algorithm to quarterly GDP series in 39 developed and 30 developing countries.<sup>6</sup> We show that the amplitude of expansions is the same in small and large countries, while contractions are significantly more pronounced in small countries. This confirms our findings of greater GDP volatility in small countries. We also find that the duration of expansions is shorter in small countries, compared to large economies. At the same time, the duration of contractions is comparable in the two groups of countries. These findings indicate potential differences in the duration of business cycles between large and small countries. Therefore, we revisit our business cycles analysis by applying a lower smoothing parameter in the Hodrick-Prescott decomposition of the series in small countries. We find our results to be robust to this amended decomposition.

Second, we use Baxter and King (1995) band pass filter to decompose the series into trend and cyclical components. The results are robust to this alternative decomposition.

Third, we explore the sensitivity of our results with respect to alternative definitions of fixed exchange rate regime, and to the duration of fiscal rules used by different countries. Again, our results go through practically unchanged.

To sum up, we believe our results put forward a novel country characteristic – size (as measured by population or labor force or land area) – that exerts a significant influence on its business cycle properties.

The prevalence of larger and more volatile shocks, higher macroeconomic volatility, lower cyclicality of investment, and strong comovement of public revenues, fiscal balance and exports with GDP constitute important vulnerabilities faced by small economies. They motivate several recommendations for policy in these countries. First, we argue that countercyclical expenditure rule or fiscal rule that forces these economies to save for the “rainy day” during good times will help to alleviate the vulnerabilities faced by small economies by cushioning them in the face of weather, terms of trade, or world demand shocks, and by stabilizing tax base and investment. Second, we argue that balanced budget rule may not have the desired effects in small economies as it would require strongly procyclical public expenditures in order to match higher cyclicality of public revenues. Third, in order to stabilize the tax base, small economies may want to rethink tax breaks for multinationals; and instead subsidize domestic investment, especially for small

> 6 These are all the countries for which we could find quarterly real GDP series with at least 30 quarters of nonmissing observations.

5