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Optimal Fiscal Policy in a Small Open Economy with Limited Commitment

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  • Sofia Bauducco
  • Francesco Caprioli

Abstract

We introduce limited commitment into a standard optimal fiscal policy model in small open economies. We consider the problem of a benevolent government that signs a risk-sharing contract with the rest of the world, and that has to choose optimally distortionary taxes on labor income, domestic debt and international debt. Both the home country and the rest of the world may have limited commitment, which means that they can leave the contract if they find it convenient. The contract is designed so that, at any point in time, neither party has incentives to exit. We define a small open emerging economy as one where the limited commitment problem is active in equilibrium. Conversely, a small open developed economy is an economy with full commitment. Our model is able to rationalize two stylized facts about fiscal policy in emerging economies: i) the volatility of tax revenues over GDP is higher in emerging economies than in developed ones; ii) the volatility of tax revenues over GDP is positively correlated with sovereign default risk.

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Bibliographic Info

Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 644.

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Date of creation: Sep 2011
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Handle: RePEc:chb:bcchwp:644

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  1. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
  2. Juan M. Sanchez & Horacio Sapriza & Gabriel Cuadra, 2009. "Fiscal Policy and Default Risk in Emerging Markets," 2009 Meeting Papers 701, Society for Economic Dynamics.
  3. Albert Marcet & Ramon Marimon, 1992. "Communication, commitment, and growth," Discussion Paper / Institute for Empirical Macroeconomics 74, Federal Reserve Bank of Minneapolis.
  4. Michael Tomz & Mark L. J. Wright, 2007. "Do countries default in “bad times”?," Working Paper Series 2007-17, Federal Reserve Bank of San Francisco.
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  7. Almuth Scholl, 2006. "Aid Effectiveness and Limited Enforceable Conditionality," 2006 Meeting Papers 292, Society for Economic Dynamics.
  8. Juan Pablo Nicolini & Francisco Buera, 2002. "Optimal Maturity of Governement Debt without state contingent bonds," Department of Economics Working Papers 016, Universidad Torcuato Di Tella.
  9. Christopher Otrok, 2000. "On Measuring the Welfare Cost of Business Cycles," Econometric Society World Congress 2000 Contributed Papers 1094, Econometric Society.
  10. Christopher Sleet, 2004. "Optimal Taxation with Private Government Information," Review of Economic Studies, Wiley Blackwell, vol. 71(4), pages 1217-1239, October.
  11. Kocherlakota, Narayana R, 1996. "Implications of Efficient Risk Sharing without Commitment," Review of Economic Studies, Wiley Blackwell, vol. 63(4), pages 595-609, October.
  12. Patrick J. Kehoe & Fabrizio Perri, 2002. "International Business Cycles with Endogenous Incomplete Markets," Econometrica, Econometric Society, vol. 70(3), pages 907-928, May.
  13. George-Marios Angeletos, 2002. "Fiscal Policy With Noncontingent Debt And The Optimal Maturity Structure," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 1105-1131, August.
  14. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  15. Christopher Sleet, 2004. "Optimal Taxation with Private Government Information," Review of Economic Studies, Oxford University Press, vol. 71(4), pages 1217-1239.
  16. Arpad Abraham & Eva Carceles-Poveda, 2010. "Competitive Equilibria with Production and Limited Commitment," Department of Economics Working Papers 10-04, Stony Brook University, Department of Economics.
  17. Abraham, Arpad & Carceles-Poveda, Eva, 2006. "Endogenous incomplete markets, enforcement constraints, and intermediation," Theoretical Economics, Econometric Society, vol. 1(4), pages 439-459, December.
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