Budget Rules and Resource Booms and Busts: A Dynamic Stochastic General Equilibrium Analysis

We develop a DSGE model to analyze and derive simple budget rules in the face of volatile public revenue from natural resources in a low-income country. We simulate the impact of resource windfalls and policy responses in a model that captures both the implications of current decisions on future growth and welfare, and the uncertainty that is intrinsic to resource prices. We ask: What rules-of-thumb does dynamic stochastic general equilibrium (DSGE) analysis provide about budgetary spending of uncertain and fluctuating resource windfalls, especially in low-income and newly resource rich developing?Our simulation results suggest three policy lessons or rules of thumb. (1) When a resource price change is positive and temporary, the best strategy is to save the revenue windfall in a sovereign fund, and use the interest income from the fund to raise citizens’ consumption over time. This strategy is preferred to investing in public capital domestically, even when private investment benefits from an enhanced public capital stock. (2) In the presence of a negative temporary resource price change however, the best strategy is to cut public investment. (3) In the presence of persistent (positive and negative) shocks, the best strategy is to combine both public investment and saving abroad in a balanced regime that provides a natural insurance against both types of price shocks.