The macroeconomics of the public sector deficit : the case of Colombia

The management of fiscal deficits and their financing in Colombia has been generally sound. This paper shows how episodes of loose fiscal policy have been minor compared to other Latin American countries. The near-crisis of the early 1980s was addressed in a timely way through a sharp fiscal adjustment. An analysis shows this adjustment to have been a combination of good luck and fundamental policy changes, with more emphasis on the latter. The means of fiscal adjustment chosen were sometimes suboptimal from the standpoint of long-run growth, which will eventually require some fiscal reform to reverse some of the measures implemented during 1985-89. The analysis of this paper shows a close relationship between the means of financing of the fiscal deficit and macroeconomic outcomes in Colombia. A simulation model traces how money-financed and domestic debt-financed fiscal deficits translate into inflation and the real interest rate. It traces the relationship between externally-financed fiscal deficits and the real exchange rate and finds that a good deal of the changes in the real exchange rates over 1975-87 are attributable to fiscal policy. Finally, these models are combined to show how the external versus domestic debt financing affects the simultaneous determination of the real exchange rate and real interest rate.