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Optimal emerging market fiscal policy when trend output growth is unobserved

  • Gregory Thwaites
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    This paper is concerned with how fiscal policy in emerging markets should respond to economic fluctuations. We model the behaviour of a fiscal authority in an emerging market country who can use external borrowing to smooth the effects of exogenous output shocks on domestic agents’ private consumption. We focus on the policy implications of the facts that (1) the GDP process in emerging markets is characterised by a relatively volatile trend growth rate, and (2) that policymakers cannot directly observe the output gap or the trend GDP growth rate. We have two key findings. First, we find that risk-averse policymakers who face EME-style output processes (ie processes dominated by shocks to the trend growth rate) should run tighter fiscal policies, with lower average debt-GDP ratios, than those in industrialised countries, who face different output processes. Second, our baseline parameterisation suggests that EME policymakers should run countercyclical fiscal policies. This result contrasts with other papers which have used optimising frameworks and the features of EME output processes to rationalise the observed procyclicality of EME fiscal policies or external balances. Simulations suggest that the welfare costs of naively running a fiscal policy that would be appropriate for an industrialised country are around 1% of certainty-equivalent consumption, but this result is sensitive to parameterisation. We find that a simple rule-of-thumb policy that stabilises the debt-GDP ratio in every period entails much smaller welfare losses.

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    File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2006/WP308.pdf
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    Paper provided by Bank of England in its series Bank of England working papers with number 308.

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    Date of creation: Sep 2006
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    Handle: RePEc:boe:boeewp:308
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    1. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," NBER Technical Working Papers 0282, National Bureau of Economic Research, Inc.
    2. Neumeyer, Pablo Andrés & Perri, Fabrizio, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," CEPR Discussion Papers 4482, C.E.P.R. Discussion Papers.
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    4. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates and the current account," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
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    10. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Debt Intolerance," NBER Working Papers 9908, National Bureau of Economic Research, Inc.
      • Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003. "Debt intolerance," MPRA Paper 13932, University Library of Munich, Germany.
    11. Hansen, Lars Peter & Sargent, Thomas J., 2003. "Robust control of forward-looking models," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 581-604, April.
    12. Rochelle M. Edge & Thomas Laubach & John C. Williams, 2004. "Learning and shifts in long-run productivity growth," Finance and Economics Discussion Series 2004-21, Board of Governors of the Federal Reserve System (U.S.).
    13. Vivian Z. Yue, 2005. "Sovereign Default and Debt Renegotiation," 2005 Meeting Papers 138, Society for Economic Dynamics.
    14. Taimur Baig & Abdul Abiad, 2005. "Underlying Factors Driving Fiscal Effort in Emerging Market Economies," IMF Working Papers 05/106, International Monetary Fund.
    15. Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March.
    16. Mark Aguiar & Manuel Amador & Gita Gopinath, 2005. "Efficient Fiscal Policy and Amplification," NBER Working Papers 11490, National Bureau of Economic Research, Inc.
    17. repec:rus:hseeco:123922 is not listed on IDEAS
    18. Jacques Miniane, 2004. "Productivity Shocks, Learning, and Open Economy Dynamics," IMF Working Papers 04/88, International Monetary Fund.
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