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Endogenous Policy Leads to Inefficient Risk-Sharing

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  • Celentani, Marco
  • Conde-Ruiz, José Ignacio
  • Desmet, Klaus

Abstract

We analyse risk-sharing and endogenous fiscal spending in a two-region model with sequentially complete markets. Fiscal policy is determined by majority voting. When policy setting is decentralized, regions choose pro-cyclical fiscal spending in an attempt to manipulate security prices to their benefit. This leads to incomplete risk-sharing, despite the existence of complete markets and the absence of aggregate risk. When a fiscal union centralizes fiscal policy, security prices can no longer be manipulated and complete risk sharing ensues. If regions are relatively homogeneous, median income residents of both regions prefer the fiscal union. If they are relatively heterogeneous, the median resident of the rich region prefers the decentralized setting.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3866.

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Date of creation: Apr 2003
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Handle: RePEc:cpr:ceprdp:3866

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Keywords: complete markets; efficiency; endogenous policy; risk-sharing;

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Cited by:
  1. José Tavares, 2012. "Fiscal Union Consensus Design Under The Threat Of Autarky," 2012 Meeting Papers 202, Society for Economic Dynamics.
  2. Mattozzi, Andrea., 2005. "Policy uncertainty, electoral securities and redistribution," Working Papers 1229, California Institute of Technology, Division of the Humanities and Social Sciences.
  3. Luque, Jaime & Morelli, Massimo & Tavares, José, 2011. "Fiscal Union Consensus Design under the Risk of Autarky," CEPR Discussion Papers 8552, C.E.P.R. Discussion Papers.
  4. Juan Prieto & Juan Gabriel Rodríguez & Rafael Salas, . "Polarization, Inequality and Tax Reforms," Working Papers 2003-23, FEDEA.
  5. Andrea Mattozzi, 2008. "Can we insure against political uncertainty? Evidence from the U.S. stock market," Public Choice, Springer, vol. 137(1), pages 43-55, October.
  6. Marco Celentani & J. Conde-Ruiz & Klaus Desmet, 2007. "Inflation in Open Economies with Complete Markets," Economic Theory, Springer, vol. 31(2), pages 271-291, May.

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