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Fiscal austerity and informality: Twin deficits as a cushion in Latin American countries

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  • Bechchani, Khalil

Abstract

This paper uncovers a new transmission channel that explains the muted effects of fiscal policy in economies with high levels of informality. Using a novel dataset on fiscal consolidations in 14 Latin American and Caribbean countries (1989–2016), I provide evidence supporting the twin deficits hypothesis in highly informal economies. Real exchange rate depreciation and improvements in the current account balance help cushion the negative impacts of fiscal consolidation. In contrast, in economies with smaller informal sectors, this mitigating effect is absent, leading to significant output contractions as a result of austerity. These findings shed new light on how informality shapes the macroeconomic consequences of fiscal policy, offering valuable insights for policymakers in emerging and developing countries.

Suggested Citation

  • Bechchani, Khalil, 2025. "Fiscal austerity and informality: Twin deficits as a cushion in Latin American countries," Economics Letters, Elsevier, vol. 246(C).
    • Handle: RePEc:eee:ecolet:v:246:y:2025:i:c:s0165176524005536
    DOI: 10.1016/j.econlet.2024.112069
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    More about this item

    Keywords

    Fiscal Consolidation; Twin Deficits; Informality; Local Projection;
    All these keywords.

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • E26 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Informal Economy; Underground Economy
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • H5 - Public Economics - - National Government Expenditures and Related Policies
    • O17 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Formal and Informal Sectors; Shadow Economy; Institutional Arrangements

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