Procyclical Fiscal Policy in Developing Countries: Truth or Fiction?

61 Pages Posted: 21 Jul 2008 Last revised: 28 Aug 2008

See all articles by Ethan Ilzetzki

Ethan Ilzetzki

London School of Economics & Political Science (LSE) - Department of Economics

Carlos A. Vegh

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS); University of Maryland - Department of Economics; University of California at Los Angeles; National Bureau of Economic Research (NBER)

Date Written: July 2008

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."

Suggested Citation

Ilzetzki, Ethan and Vegh, Carlos A., Procyclical Fiscal Policy in Developing Countries: Truth or Fiction? (July 2008). NBER Working Paper No. w14191, Available at SSRN: https://ssrn.com/abstract=1165519

Ethan Ilzetzki

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Carlos A. Vegh (Contact Author)

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS) ( email )

1740 Massachusetts Avenue, NW
Washington, DC 20036-1984
United States

University of Maryland - Department of Economics ( email )

College Park, MD 20742
United States

University of California at Los Angeles ( email )

Box 951477
Los Angeles, CA 90095-1477
United States
310-825-7371 (Phone)
310-825-9528 (Fax)

HOME PAGE: http://vegh.sscnet.ucla.edu

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