Working Paper: NBER ID: w14191
Authors: Ethan Ilzetzki; Carlos A. Vegh
Abstract: A large empirical literature has found that fiscal policy in developing countries is procyclical, in contrast to high-income countries where it is countercyclical. The idea that fiscal policy in developing countries is procyclical has all but reached the status of conventional wisdom. This has sparked a growing theoretical literature that attempts to explain such a puzzle. Some authors, however, have suggested that procyclical fiscal policy could be more fiction than truth since, by and large, the current literature has ignored endogeneity problems and may have simply misidentified a standard expansionary effect of fiscal policy. To settle this issue of causality, we build a novel quarterly dataset for 49 countries covering the period 1960-2006, and subject the data to a battery of econometric tests: instrumental variables, simultaneous equations, and time-series methods. We find overwhelming evidence to support the idea that procyclical fiscal policy in developing countries is in fact truth and not fiction. We also find evidence that fiscal policy is expansionary -- a channel disregarded by the existing literature -- lending empirical support to the notion that when "it rains, it pours."
Keywords: Fiscal Policy; Procyclicality; Developing Countries; Econometric Analysis
JEL Codes: E62; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Expansionary Business Cycle Shock (E32) | Government Consumption (H59) |
| Government Consumption (H59) | Output (Y10) |
| Procyclical Fiscal Policy (E62) | Output (Y10) |
| Fiscal Policy (E62) | Business Cycle (E32) |