Economy & Business Journal of International Scientific Publications www.scientific-publications.net MACROECONOMICS EFFECT OF FISCAL POLICY IN TRANSITION ECONOMIES: THE CASE REPUBLIC OF MACEDONIA Besnik Fetai, Selajdin Abduli South East European University, Ilindenska bb, Republic of Macedonia Abstract The objective of this paper is to investigate the effect of fiscal policy in small open transition economy. This paper employs, Granger- Causality test, Impulse Response Function and Forecast Error Decomposition, in order to assess the impact of fiscal policy on real GDP and prices. In this finding, all econometrics result do not show a conventional Keynesian effect of fiscal policy on real economic activity due to the counteracting effect of the monetary policy reaction. This causes a crowding out effect. Therefore, the results suggest that there is no coordination between fiscal and monetary policy. Moreover, the results from the Granger Causality test and Impulse Response Function show that the best fiscal policy for stimulating the economy appears to be one of tax-cuts. However, a change in taxation may produce a short-lived effect on real GDP; but, such action is likely to generate higher burdens in the future. In addition, the higher burdens are likely to have long-term consequences that far outweigh any short-term benefits in terms of real GDP. Key words: Fiscal policy; Economic growth; Transition Economies; Granger – Causality test; Structural Vector Autoregressive 1. INTRODUCTION The aim of this paper is to examine the impact of fiscal policy on real GDP and prices. For this purpose, I use Granger Causality test and a Structural Vector Autoregressive (SVAR-henceforth), aiming to identify the fiscal shock on real GDP and prices. Fiscal policy and its effect have traditionally involved great interest from many researchers. However, the questions of the appropriate fiscal measures have been increasing the interest particularly during the global financial crisis. Recently, in the literature on SVAR, some consideration has been given to the investigation of the macroeconomic effects of fiscal policy (e.g. Blanchard and Perotti, 2002; Fatás and Mihov, 2003, 2004; Mountford and Uiling, 2009; Restrepo and Rincón, 2006; Rarytska, 2003). Ever since the foundation of the Euro Area, there has been a growing interest in the reexamination of fiscal policy as an effective instrument for smoothing business cyclical fluctuations. The emergence of such a system with a single Central Bank has left the European countries with fiscal policy as their only instrument for macroeconomic stabilization (Fatás and Mihov, 2003). Other reason for reexamination of the macroeconomic effect of fiscal policy is to determine whether fiscal policy can be considered as a complementary instrument of monetary policy in achieving macroeconomic stability during the financial crisis. Regarding the countries in transition, little attention has been devoted to the macroeconomic effect of fiscal policy, even though these countries are interesting for their variety of types of economic growth. An important argument for imposing various fiscal restrictions is based on the assumption that fiscal discretion might harm macroeconomic stability (Fatás and Mihov, 2003). While it is undeniable that fiscal policy has the potential of being destabilizing, it is also clear that fiscal policy can smooth out business cyclical fluctuations via expansionary public spending or tax cuts during periods of recession and contractionary policies during periods of expansion (Fatás and Mihov, 2003). Often both sides of the budget are changed (increasing/decreasing government spending and reducing/increasing tax) in order to promote economic growth, as is the case in the Republic of Macedonia, which is the topic of Page 1035 ISSN 1314-7242, Volume 8, 2014