Commodity-exporting economies are often characterized as having needlessly pro-cyclical fiscal policy: spending when commodity prices are high, and then cutting back when commodity prices fall. In this paper we ask (i) how procyclical is fiscal policy for commodity exporters empirically? (ii) how procyclical should it be? (iii) how this changes with features of the economy, such the exchange rate (ER) regime or the commodity being exported? Using a New Keynesian model, we show that optimal fiscal policy is actually pro-cyclical in countries with flexible ERs, because commodity price shocks are usually highly persistent, and so should be spent according to the permanent income hypothesis. In contrast, fiscal policy should be countercyclical in countries with fixed ERs to smooth the business cycle. Empirically, we estimate the degree of pro-cyclicality as the Marginal Propensity to Spend (MPS) an extra dollar of commodity revenues, and show that the MPS is pro-cyclical overall. Consistent with theory, we show that (i) the MPS is more procyclical in countries with floating ERs than those with fixed ERs, and (ii) in countries with floating ERs the MPS increases with the persistence of the price shocks of the commodities being exported. However, in countries with fixed ERs and persistent commodity price shocks, we find that fiscal policy is more pro-cyclical than is optimal.
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