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Optimal emerging market fiscal policy when trend output growth is unobserved

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  • Gregory Thwaites
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    Abstract

    This paper is concerned with how fiscal policy in emerging markets should respond to economic fluctuations. We model the behaviour of a fiscal authority in an emerging market country who can use external borrowing to smooth the effects of exogenous output shocks on domestic agents’ private consumption. We focus on the policy implications of the facts that (1) the GDP process in emerging markets is characterised by a relatively volatile trend growth rate, and (2) that policymakers cannot directly observe the output gap or the trend GDP growth rate. We have two key findings. First, we find that risk-averse policymakers who face EME-style output processes (ie processes dominated by shocks to the trend growth rate) should run tighter fiscal policies, with lower average debt-GDP ratios, than those in industrialised countries, who face different output processes. Second, our baseline parameterisation suggests that EME policymakers should run countercyclical fiscal policies. This result contrasts with other papers which have used optimising frameworks and the features of EME output processes to rationalise the observed procyclicality of EME fiscal policies or external balances. Simulations suggest that the welfare costs of naively running a fiscal policy that would be appropriate for an industrialised country are around 1% of certainty-equivalent consumption, but this result is sensitive to parameterisation. We find that a simple rule-of-thumb policy that stabilises the debt-GDP ratio in every period entails much smaller welfare losses.

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    Bibliographic Info

    Paper provided by Bank of England in its series Bank of England working papers with number 308.

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    Date of creation: Sep 2006
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    Handle: RePEc:boe:boeewp:308

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    1. Andrew T. Levin & John C. Williams, 2003. "Robust monetary policy with competing reference models," Working Paper Series 2003-10, Federal Reserve Bank of San Francisco.
    2. Aguiar, Mark & Gopinath, Gita, 2006. "Defaultable debt, interest rates and the current account," Journal of International Economics, Elsevier, vol. 69(1), pages 64-83, June.
    3. Pablo A. Neumeyer & Fabrizio Perri, 2004. "Business cycles in emerging economies: the role of interest rates," Staff Report 335, Federal Reserve Bank of Minneapolis.
    4. Mark Aguiar & Gita Gopinath, 2007. "Emerging Market Business Cycles: The Cycle Is the Trend," Journal of Political Economy, University of Chicago Press, vol. 115, pages 69-102.
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    7. Rochelle M. Edge & Thomas Laubach & John C. Williams, 2004. "Learning and shifts in long-run productivity growth," Working Paper Series 2004-04, Federal Reserve Bank of San Francisco.
    8. Jacques Miniane, 2004. "Productivity Shocks, Learning, and Open Economy Dynamics," IMF Working Papers 04/88, International Monetary Fund.
    9. Yue, Vivian Z., 2010. "Sovereign default and debt renegotiation," Journal of International Economics, Elsevier, vol. 80(2), pages 176-187, March.
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    11. Giuliano, Paola & Turnovsky, Stephen J., 2003. "Intertemporal substitution, risk aversion, and economic performance in a stochastically growing open economy," Journal of International Money and Finance, Elsevier, vol. 22(4), pages 529-556, August.
    12. Mark Aguiar & Manuel Amador & Gita Gopinath, 2005. "Efficient Fiscal Policy and Amplification," NBER Working Papers 11490, National Bureau of Economic Research, Inc.
    13. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Debt Intolerance," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 1-74.
    14. Hansen, Lars Peter & Sargent, Thomas J., 2003. "Robust control of forward-looking models," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 581-604, April.
    15. Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March.
    16. Young Lee & Taeyoon Sung, 2007. "Fiscal Policy, Business Cycles and Economic Stabilisation: Evidence from Industrialised and Developing Countries," Fiscal Studies, Institute for Fiscal Studies, vol. 28(4), pages 437-462, December.
    17. repec:rus:hseeco:123922 is not listed on IDEAS
    18. Aaron Tornell & Philip Lane, 1999. "Are Windfalls a Curse? A Non-Representative Agent Model of the Current Account and Fiscal Policy," NBER Working Papers 4839, National Bureau of Economic Research, Inc.
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