DP19586 Commodity Prices and Fiscal (Pro)Cyclicality
Consensus holds that Emerging Markets and Developing Economies (EMDEs) engage in procyclical fiscal behavior. We emphasize that considering conditional responses to macroeconomic shocks is crucial when evaluating fiscal cyclicality, as neglecting this can result in significant biases. This study investigates the effects of exogenous commodity price shocks on fiscal variables in EMDEs by exploiting major narrative episodes and the heterogeneous exposure of countries to these shocks. Our results reveal that, following an expansionary shift in the terms of trade, fiscal authorities moderately increase taxes and raise government spending, leading to an improvement in the primary balance. These findings contrast with conventional wisdom but align with the optimal policy response to export price shocks predicted by a multi-good small open economy model with incomplete financial markets. We also highlight the role of institutional quality in shaping fiscal policy responses.
