Tax rates are another important fiscal policy instrument; however, data for Paraguay are not available. From Figure 1.2(c) it is easy to see that government consumption is strongly pro-cyclical during 1994-2012, with the unconditional correlation equal to 0.85. Figure 1.2(d) plots public investment against GDP. It is easy to see that its dynamics differ significantly from those of public consumption. However, we still find that government investment is pro-cyclical, although its correlation with GDP is much lower at 0.10. It is also interesting to note that the co-movement of public investment with sectoral output is quite distinct from the corresponding co-movements of government consumption. While the latter is positively correlated with both agricultural and nonagricultural output, government investment exhibits a negative correlation with agricultural output (equal to -0.18), but a positive correlation with non-agricultural output (equal to 0.16).

Overall, the results above suggest to us that both monetary and fiscal policies tend to be procyclical in Paraguay and, therefore, may be important drivers of its business cycles.

Among external factors, fluctuations in terms of trade have been viewed as an important source of business cycle volatility in developing countries. In developed economies terms of trade tend to permeate the economy mainly through oil price movements. In developing countries, these effects are exacerbated by two facts: one is that these economies tend to be heavily specialized in a few commodities making them particularly sensitive to commodity price fluctuations; and two is that they are often dependent on imports of intermediate inputs and capital goods. Mendoza (1995) shows in a three-sector intertemporal model that terms of trade shocks account for nearly 50 percent of GDP volatility in developed and developing countries. Kose and Riezman (2001) also show that fluctuations in international relative prices explain 44 percent of the output volatility in Africa. Kose (2002) breaks the import prices into the price of imported capital and the price of imported inputs and finds that the world price shocks are responsible for more than 80 percent of output fluctuations in a representative developing economy. Using data for 3 developed economies (Australia, Canada, and New Zealand) and 2 developing countries (Chile and Mexico), Lubik and Teo (2005) report a smaller contribution of terms of trade shocks to business cycles fluctuation.

Figure 1.2(e) shows terms of trade and GDP series in Paraguay and suggests a negative correlation between them, equal to -0.56. This negative correlation is even stronger for non-agricultural GDP at -0.63, while it is positive for agricultural GDP at 0.08, in line with the arguments above.

To capture foreign demand conditions for Paraguayan exports, we consider GDP in four main trade partners of Paraguay. More precisely, we construct a weighted foreign GDP using GDP data for Argentina, Brazil, Chile and Uruguay, where their export shares in Paraguayan exports are used as weights. The remaining export share is allocated to the US and its GDP in the construction of this aggregate foreign demand measure. The dynamics of this measure during our sample period together with Paraguayan GDP are shown in Figure 1.2(f). The strong positive correlation between the two clearly stands out from that figure. Indeed, the unconditional correlation of aggregate GDP with the foreign demand is 0.82. It is particularly high for non-agricultural GDP, at 0.80, but falls for agricultural GDP to 0.30.

Another external variable that is important for understanding business cycle fluctuations in developing countries is the world interest rate. Thus, Calvo, Leiderman and Reinhart (1993) show that lower international interest rates have led to an increase in international capital inflows into