Government Investment and the Business Cycle in Oil-Exporting Countries

Juan Guerra-Salas

Latest version: November 20, 2014 (PDF)

Abstract: How should governments that receive natural resource rents manage them so as to avoid inducing boom-bust cycles? This paper focuses on oil-exporting countries and argues that government investment of oil revenue, if not adequately smoothed over time, can propagate oil price shocks and exacerbate the business cycle. I use a structural vector autoregression to estimate the effects of an oil price shock on the Mexican economy and find that it generates a temporary expansion of government investment and a boom in private economic activity. In Norway, the government does not increase investment in response to a similar shock, and the economy expands modestly. I then develop a small open economy dynamic stochastic general equilibrium model that provides an explanation for the propagation mechanism. An expansionary response of government investment to a positive oil price shock raises the stock of public capital, which is an input in the production of goods and services. This increases the productivity of the private sector, triggering an expansion. Under an alternative prudent policy by which the government saves part of its oil revenue and smooths investment, the shock generates a milder and more long-lasting expansion. The paper, therefore, highlights the productivity-enhancing effect of public capital as a channel through which fiscal policy amplifies shocks.

Keywords: Government investment, oil price shock, fiscal policy, business cycle, small open economy.

JEL classification codes: E32, E62, F41, Q33.