Do Good Institutions Promote Countercyclical Macroeconomic Policies?

Date01 October 2016
Published date01 October 2016
©2016 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
doi: 10.1111/obes.12132
Do Good Institutions Promote Countercyclical
Macroeconomic Policies?*
esar Calder ´on, Roberto Duncan,and Klaus Schmidt-Hebbel§
The World Bank, 1818 H Street NW, Washington, DC 20433, USA (e-mail:
Department of Economics, Ohio University, Bentley Annex 349, Athens, OH 45701, USA
§Instituto de Econom´
ia, Pontificia Universidad Cat´olica de Chile, Vicuna Mackenna 4860,
Macul, Santiago, Chile (e-mail:
The literature has argued that developingcountries are unable to adopt countercyclical mon-
etary and fiscal policies due to financial imperfections and unfavourable political-economy
conditions. Using a world sample of up to 112 industrial and developingcountries for 1984–
2008, we find that the level of institutional quality playsa key role in countries’ ability and
willingness to implement countercyclical macroeconomic policies. Countries with strong
(weak) institutions adopt countercyclical (procyclical) macroeconomic policies, reflected
in extended monetary policy and fiscal policy rules. The threshold levels of institutional
quality at which policies are acyclical are found to be similar for monetary and fiscal policy.
I. Introduction
Macroeconomic policies are geared in principle towards stabilizing business-cyclefluctua-
tions. Governments and central banks implement countercyclical polices when they adjust
their policy instruments to smoothen expansions and recessions. That is, policy-makers
adopt expansionary (contractionary) policies in recessions (booms).
There is ample evidence about the ability of industrial economies to conduct counter-
cyclical fiscal policies, especially in Europe (see Melitz, 2000; Gal´
i and Perotti, 2003). As
documented by the estimation of their monetary policy rules, central banks of advanced
countries also tend to implement countercyclical policies (e.g. Lubik and Schorfheide,
JEL Classification numbers: E43, E52, E58, E62, E63.
*This paper previously circulated under the title ‘Institutions and Cyclical Properties of Macroeconomic Policies
in the Global Economy’. We thank seminar participants at the International Monetary Fund, the World Bank, the
European Central Bank, the Annual Meetings of the Latin American and Caribbean Economic Association, the
Annual Meetings of the Chilean Economic Society, and the Workshop for Young Economists at UDEP (Lima)
for helpful comments. We are also indebted to the editor, two anonymous referees, and Alberto Humala for very
valuable comments and suggestions. FafaliAdanu, Soo Hyun Hwang, and Ke Xu provided able research assistance.
Schmidt-Hebbel gratefully acknowledges financial support provided bythe Fondecyt research project No. 1060175.
Institutions and countercyclical policies 651
2007; Sack and Wieland, 2007). Recently, most OECD countries delivered a strong coun-
tercyclical policy response to the 2008–09 global financial crisis by lowering interest rates,
implementing unorthodox monetary and credit easing measures, and deploying fiscal stim-
ulus packages (IMF, 2009; OECD, 2009). However, the cyclical stance of macroeconomic
policies in developing countries is more disputed. Earlier research suggests that monetary
and fiscal policies in developing countries –and, especially, in LatinAmerica – are predom-
inantly procyclical.1Procyclical policies are conducted by governments that cut taxes and
increase spending, and by central banks that relax monetary policy during booms while
adopting contractionary policies during busts. What drives this (potentially) destabilizing
This paper argues that policy-makers are more likely to stabilize business cycle fluc-
tuations in countries with stronger institutions.2Strictly speaking, we argue that there is
a robust statistical association between institutional quality and the cyclicality of macro-
economic policies, which might be interpreted as a causality link in the light of exist-
ing theoretical models that are reviewed below. Our conjecture is that countries with
weak institutions are unable or unwilling to pursue countercyclical policies.3Put dif-
ferently, we anticipate that countries with strong institutions will implement contrac-
tionary policies during booms and expansionary policies during recessions. We test this
hypothesis using a large panel data set of up to 112 countries with 25 years of annual
This paper expands previous empirical work focused mainly on fiscal policy. Here
we examine symmetrically the cyclical properties of both monetary and fiscal policy.
Monetary and fiscal policy reaction functions in this paper are extensions of standard
policy rules found in the literature on Taylor rules (Taylor, 1993a,b, 1995, 2000), fiscal
policy rules (Taylor, 2000; Braun, 2001; Lane, 2003) or both (Taylor, 2000; Chadha and
Nolan, 2007). We extend standard rules by including the interaction between the business
cycle and the strength of the institutional framework.Our main focus is on a broad measure
of institutional quality as a key determinant of policy-makers’ ability and willingness to
adopt countercyclical fiscal and monetary policies. Therefore, this paper complements and
improves upon previous work about the role of policy credibility (as proxied by the risk
premium on sovereign debt) in the cyclical stance of macroeconomic policies for a smaller
set of developing countries (see Calder´on and Schmidt-Hebbel, 2003; Calder ´on, Duncan
and Schmidt-Hebbel, 2004).
Our empirical assessment is conducted for a sample comprised by 84 emerging and
developingcountries and 31 developed countries. Weuse 1984–2007 data from 84 countries
for our monetary policy regressions and 1984–2008 data from 112 countries for our fiscal
policy regressions. This implies exploiting large panel samples that range from 1084 to
1See Hausmann and Stein (1996), Gavin and Perotti (1997a), Kaminsky, Reinhart and V´egh (2004), Talvi and
egh (2005), Ilzetzki and V´egh (2008).
2In several developing economies, such as Chile, Korea, Malaysia, and Thailand, expansionary policies were
adopted during 2001–03, a period of cyclical weakness in these economies. More recently, Brazil, Chile, China,
India, Korea, and Mexico were among manydeveloping countries that adopted expansionary policies in response to
the 2008–09 global financial crisis and subsequent domestic cyclical weakness.
3By unwillingness, we refer to the case in which policy-makers do not havesufficient incentives to pursue certain
policies, even when they are able to do so.
©2016 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd

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