Procyclical Fiscal Policy in Developing Countries: Truth or Fiction?

Ethan Ilzetzki and Carlos Vegh

No 14191, NBER Working Papers from National Bureau of Economic Research, Inc

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."

JEL-codes: E62 F41 (search for similar items in EconPapers)
Date: 2008-07
New Economics Papers: this item is included in nep-cba, nep-mac and nep-opm
Note: IFM
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Citations: View citations in EconPapers (360)

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