The Cyclical Behavior of Fiscal Policy: Its Determinants and Fiscal Rule

Fiscal policy is an important macroeconomic policy tool for dampening the amplitude of business cycles in the oil-exporting countries. This importance derives from the fact that these countries have the highest volatility of output in the world and that a majority of countries have exchange rate pegs or manage their exchange rates, thereby limiting the scope of monetary policy. The main objective of this paper is to characterize and explain the determinants of the cyclical behavior of fiscal policy in Iran during 1979-2011. To this end, we overcome the endogeneity problem using the Generalized Methods of Moments (GMM). We find that fiscal policy is strongly pro-cyclical and oil price volatility and quality of institutions have an important role in determining the degree of cyclicality in fiscal policy. In addition, we focus on the role Played by the fiscal rule, which appears to be a key determinant of a country’s ability to escape the pro-cyclicality trap and actually become countercyclical. However, we find that national fiscal rules defined in the Third Development Plan as expenditure rule and oil Price-based rule (Foreign Exchange Reserve Account (FRA) Foundation) do not affect the reduction of fiscal policy pro-cyclicality. Furthermore, we conclude that Iran is unable to run countercyclical fiscal policies if it has weak institutions quality.