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Endogenous Policy Leads to Inefficient Risk Sharing

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  • Marco Celentani
  • J. Ignacio Conde-Ruiz
  • Klaus Desmet
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    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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    File URL: http://documentos.fedea.net/pubs/dt/2003/dt-2003-08.pdf
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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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    1. Persson, Torsten & Tabellini, Guido, 1996. "Federal Fiscal Constitutions: Risk Sharing and Moral Hazard," Econometrica, Econometric Society, vol. 64(3), pages 623-46, May.
    2. Alberto Alesina & Roberto Perotti, 1995. "Economic Risk and Political Risk in Fiscal Unions," NBER Working Papers 4992, National Bureau of Economic Research, Inc.
    3. Persson, Torsten & Tabellini, Guido, 1996. "Federal Fiscal Constitutions: Risk Sharing and Redistribution," Journal of Political Economy, University of Chicago Press, vol. 104(5), pages 979-1009, October.
    4. Grandmont, Jean-Michel, 1978. "Intermediate Preferences and the Majority Rule," Econometrica, Econometric Society, vol. 46(2), pages 317-30, March.
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    Cited by:
    1. Mattozzi, Andrea., 2005. "Policy uncertainty, electoral securities and redistribution," Working Papers 1229, California Institute of Technology, Division of the Humanities and Social Sciences.

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