Study the Impact of Fiscal Policy as a Transmission Mechanism of Oil Shocks on Iranian Economy Using a Structural Vector Autoregressive Model

In countries like Iran, where the government relies heavily on oil revenue, the response of fiscal policy to oil revenue fluctuations is a key transmission mechanism of oil revenue volatility. Several studies have documented various transmission channels through which oil price shocks affect economic activities in developed oil importing countries. But, regarding oil exporting countries, there are few such studies. According to them, government expenditure has the effects of diminishing returns; and, over-expanding by crowding out of private investment will decrease economic growth.Moreover, inefficiency, distortion in allocation of resources and corruption are other channels that have negative effects on output.
The aim of this study is to assess the mechanism in which oil shocks affect economic variables of an oil exporting country. For this purpose, we provide evidence on Iran, an oil exporter where a positive oil revenue shock generates an expansion in consumption and investment by both the private and public sectors. we document the effects of an unexpected increase in the oil revenue, on several variables which are GDP, government consumption of goods and services, government investment, private consumption, and private investment.
The effects of structural shocks on that variables have been assessed using a Structural Vector Auto Regressive (SVAR) Model in two different situations with dependence and independence of government budget to oil revenue. Due to data availability, however, we study a more recent period, from 19959 to 2015. We assumed the oil revenue is exogenous, so that it is only affected by its lagged values and a shock and the logarithms of the variables are detrended by Hodrick–Prescott Filter.
As a first step of the empirical analysis, we carried out unit root tests for all of the variables and the lag length criteria were employed to select optimal lag order of a VAR model. To analyze the relationships between variables with the SVAR model, we estimated matrix B, the coefficients of structural shocks were recovered and their impacts on the system were investigated through impulse responses. To derive the set of identifications, use can be made of the economic theory which imposes a set of over-identifying restrictions on the coefficients of matrix B. Considering the existence of five endogenous variables, x = {GDP , GC , GI , C , I}and one exogenous variable, OR, we have six equations. By restrictions on matrix B, we may have an over-identified structural VAR. In this paper we have two different matrix B with different restrictions to show the dependence and independence of government budget to oil revenue.
The resulting structural parameter estimates of matrixes B are given and comparing them indicate that a positive oil revenue shock generates an expansion in consumption and investment by both the private and public sectors. Government investment expands about 2 percent above trend a few quarters after a 4.5 percent oil revenue shock hits the economy. Finally, we find that when fiscal policy is assumed to be unrelated with oil revenue the response of economic variables to oil shocks is smoothed. We find that fiscal policy is the main propagation mechanism that transmits the oil shocks to the economy.
The results of the paper carry important implications for the formulation of fiscal policy in oil-exporting countries like Iran. These countries could prevent large swings in economic activity by saving oil windfalls and investing them gradually. Therefore, controlling government expenditure as fiscal policy instrument effectively insulating the economy from the volatility of oil revenue.