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Endogenous Policy Leads to Inefficient Risk Sharing

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  • Marco Celentani
  • J. Ignacio Conde-Ruiz
  • Klaus Desmet

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 FEDEA in its series Working Papers with number 2003-08.

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Handle: RePEc:fda:fdaddt:2003-08

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Cited by:
  1. Luque, Jaime & Morelli, Massimo & Tavares, José, 2011. "Fiscal Union Consensus Design under the Risk of Autarky," CEPR Discussion Papers, C.E.P.R. Discussion Papers 8552, C.E.P.R. Discussion Papers.
  2. Celentani, Marco & Conde-Ruiz, José Ignacio & Desmet, Klaus, 2004. "Inflation in Open Economies with Complete Markets," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4385, C.E.P.R. Discussion Papers.
  3. Mattozzi, Andrea, 2004. "Can we insure against political uncertainty? Evidence from the U.S. Stock Market," Working Papers, California Institute of Technology, Division of the Humanities and Social Sciences 1207, California Institute of Technology, Division of the Humanities and Social Sciences.
  4. José Tavares, 2012. "Fiscal Union Consensus Design Under The Threat Of Autarky," 2012 Meeting Papers, Society for Economic Dynamics 202, Society for Economic Dynamics.
  5. Mattozzi, Andrea., 2005. "Policy uncertainty, electoral securities and redistribution," Working Papers, California Institute of Technology, Division of the Humanities and Social Sciences 1229, California Institute of Technology, Division of the Humanities and Social Sciences.
  6. Juan Prieto & Juan Gabriel Rodríguez & Rafael Salas, . "Polarization, Inequality and Tax Reforms," Working Papers, FEDEA 2003-23, FEDEA.

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