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Fiscal Policy and Macroeconomic Uncertainty in Developing Countries: The Tale of the Tormented Insurer

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  • Enrique G. Mendoza
  • P. Marcelo Oviedo

Abstract

Governments in emerging markets often behave like a "tormented insurer," trying to use non-state-contingent debt instruments to avoid cuts in payments to private agents despite large fluctuations in public revenues. In the data, average public debt-GDP ratios decline as the variability of revenues increases, primary balances and current expenditures follow cyclical patterns sharply at odds with the countercyclical patterns of industrial countries, and the cyclical variability of public expenditures exceeds that of private expenditures by a wide margin. This paper proposes a model of a small open economy with incomplete markets that can rationalize this behavior. In the model a fiscal authority makes optimal expenditure and debt plans given shocks to output and revenues, and private agents make optimal consumption and asset accumulation plans. Quantitative analysis of the model calibrated to Mexico yields a negative relationship between average public debt and revenue variability similar to the one observed in the data. The model mimics Mexico's GDP correlations of government purchases and the primary balance. The ratio of public-to-private expenditures fluctuates widely and the implied welfare costs dwarf conventional estimates of negligible benefits of risk sharing and consumption smoothing.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12586.

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Date of creation: Oct 2006
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Handle: RePEc:nbr:nberwo:12586

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  1. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, Econometric Society, vol. 59(2), pages 371-96, March.
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  7. Lane, Philip & Milesi-Ferretti, Gian Maria, . "External Wealth of Nations," Instructional Stata datasets for econometrics extwealth, Boston College Department of Economics.
  8. Michael Gavin & Roberto Perotti, 1997. "Fiscal Policy in Latin America," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 1997, Volume 12, pages 11-72 National Bureau of Economic Research, Inc.
  9. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 87(5), pages 940-71, October.
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  11. Talvi, Ernesto & Vegh, Carlos A., 2005. "Tax base variability and procyclical fiscal policy in developing countries," Journal of Development Economics, Elsevier, Elsevier, vol. 78(1), pages 156-190, October.
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  14. Oya Celasun & Xavier Debrun & Jonathan David Ostry, 2006. "Primary Surplus Behavior and Risks to Fiscal Sustainability in Emerging Market Countries," IMF Working Papers, International Monetary Fund 06/67, International Monetary Fund.
  15. Enrique G. Mendoza, 1991. "Capital Controls and the Gains from Trade in a Business Cycle Model of a Small Open Economy," IMF Staff Papers, Palgrave Macmillan, vol. 38(3), pages 480-505, September.
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