Fiscal Policy Adjustment to Shocks in Commodity-Producing Countries

This paper investigates the optimal scal policy adjustment to adverse terms of trade shocks by commodity-producing countries within a general equilibrium model,which allows for explicit distinction between public investment and government consumption. As the private sector has limited room for maneuver in correcting the shock itself, the public sector is used to isolate the economy from external fluctuations. The ability of fiscal policy to shield the economy from external shocks critically depends on instruments available to government. In the presence of international capital market imperfections, the shock is absorbed primarily through a combination of reduced expenditure and higher taxes. Cuts in expenditure are carried out mostly through cuts in public investment, with the change in the levelof public investment being about ten times larger than the change in government consumption. Public investment is thus the main shock absorber in this situation and is highly pro-cyclical. In the absence of distortions on the international capital markets, government shifts from domestic sources to external sources to absorb the shock and resorts to increased external borrowing to finance the shortfall in revenues. In this case, responses of both public investment and government consumption are more smoothed and less pro-cyclical, whereas tax rate falls.