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Fiscal Policy and Financial Depth

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  • Ricardo J. Caballero
  • Arvind Krishnamurthy

Abstract

Most economists and observers place the lack of fiscal discipline at the core of the recent Argentine crisis. This begs the question of how countries like Belgium or Italy (pre-Maastricht) could run large fiscal deficits and accumulate debts far beyond those of Argentina, without experiencing crises nearly as dramatic as that of Argentina? Why is it that Argentina cannot act like Belgium or Italy and pursue expansionary fiscal policy during downturns? We argue that advanced and emerging economies differ in their financial depth, and show that lack of financial depth constrains fiscal policy in a way that can overturn standard Keynesian fiscal policy prescriptions. We also provide empirical support for this viewpoint. Crowding out is systematically larger in emerging markets than in developed economies. More importantly, this difference is extreme during crises, when the crowding out coefficient exceeds one in emerging market economies.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10532.

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Date of creation: May 2004
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Handle: RePEc:nbr:nberwo:10532

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  1. Rafael La Porta & Florencio Lopez-de-Silane & Andrei Shleifer & Robert W. Vishny, 1996. "Law and Finance," NBER Working Papers 5661, National Bureau of Economic Research, Inc.
  2. Alberto Alesina & Roberto Perotti, 1995. "Fiscal Expansions and Fiscal Adjustments in OECD Countries," NBER Working Papers 5214, National Bureau of Economic Research, Inc.
  3. Beck, Thorsten & Demirguc-Kunt, Asli & Levine, Ross, 1999. "A new database on financial development and structure," Policy Research Working Paper Series 2146, The World Bank.
  4. Fernando A. Broner & Guido Lorenzoni & Sergio L. Schmukler, 2007. "Why Do Emerging Economies Borrow Short Term?," NBER Working Papers 13076, National Bureau of Economic Research, Inc.
  5. Hodrick, Robert J & Prescott, Edward C, 1997. "Postwar U.S. Business Cycles: An Empirical Investigation," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 29(1), pages 1-16, February.
  6. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  7. George-Marios Angeletos & Christian Hellwig & Alessandro Pavan, 2003. "Coordination and Policy Traps," NBER Working Papers 9767, National Bureau of Economic Research, Inc.
  8. International Monetary Fund, 1996. "The Economic Content of Indicators of Developing Country Creditworthiness," IMF Working Papers 96/9, International Monetary Fund.
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