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Fiscal deficits, banking crises and policy reversal in a semi-open economy

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  • Sharma, Anurag
  • Jha, Raghbendra

Abstract

We study the effect of domestic policies and external shocks in a semi-open economy characterized by incomplete liberalization of the financial sector. We argue that in such transition economies stabilization programs can have a negative impact on the fiscal imbalances, offsetting to some extent the very achievement of the stabilization program. We develop a simple general equilibrium model which allows propagation of shocks in the presence of government guarantees and imperfect capital mobility. We also empirically test the impact of positive foreign interest shock on the Indian economy using a reduced form VAR approach. The econometric evidence, though broadly consistent with the main predictions of the model, suggests no significant impact of foreign interest rate shock on output and credit. We conclude that incomplete liberalization of the financial sector in transition economies has two effects. It reduces i) exposure to external financial shocks (like the current credit crisis) and ii) ability to deal with real sector shocks (which may arise from global recession in the medium term) due to endogenous policy reversals and presence of government guarantees.

Suggested Citation

  • Sharma, Anurag & Jha, Raghbendra, 2012. "Fiscal deficits, banking crises and policy reversal in a semi-open economy," Economic Modelling, Elsevier, vol. 29(2), pages 271-282.
  • Handle: RePEc:eee:ecmode:v:29:y:2012:i:2:p:271-282
    DOI: 10.1016/j.econmod.2011.10.005
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    Cited by:

    1. Raghbendra Jha, 2004. "The Political Economy of Recent Economic Growth in India," ASARC Working Papers 2004-12, The Australian National University, Australia South Asia Research Centre.
    2. Raghbendra Jha, 2007. "The Indian Economy: Current Performance and Short-Term Prospects," ASARC Working Papers 2007-04, The Australian National University, Australia South Asia Research Centre.

    More about this item

    Keywords

    Stabilization; Banking crises; Policy reversal; VAR; India;

    JEL classification:

    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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