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Optimal Fiscal Policy in a Small Open Economy and the Structure of International Financial Markets

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  • Josué Fernando Cortés Espada
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    Abstract

    This paper characterizes the behavior of debt and tax rates in a small open economy under both complete and incomplete markets. First, I show hat when the government follows an optimal fiscal policy and agents have access to complete markets, the value of the government’s debt portfolio is negatively correlated with government spending, and positively correlated with productivity and output, while output, labor, consumption and the tax rate are uncorrelated with government spending shocks. The stochastic processes followed by these variables inherit the serial-correlation properties of the stochastic process of the productivity shock. Second, I show that if agents can only buy and sell one-period risk-free bonds, public debt shows more persistence than other variables, and it is negatively correlated with productivity and output, and positively correlated with government spending. Moreover, the tax rate is positively correlated with government spending, while consumption is negatively correlated.

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    File URL: http://www.banxico.org.mx/publicaciones-y-discursos/publicaciones/documentos-de-investigacion/banxico/%7BA471012C-812B-242B-13DD-AAA2ECA90ED0%7D.pdf
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    Bibliographic Info

    Paper provided by Banco de México in its series Working Papers with number 2007-07.

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    Date of creation: Mar 2007
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    Handle: RePEc:bdm:wpaper:2007-07

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    Keywords: Complete markets; Incomplete markets; Optimal fiscal policy;

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    1. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc.
    2. Correia, Maria Isabel Horta & Neves, Joao C & Rebelo, Sérgio, 1994. "Business Cycles in a Small Open Economy," CEPR Discussion Papers 996, C.E.P.R. Discussion Papers.
    3. V. V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1993. "Optimal Fiscal Policy in a Business Cycle Model," NBER Working Papers 4490, National Bureau of Economic Research, Inc.
    4. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
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