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Endogenous Policy Leads to Inefficient Risk-Sharing

  • Celentani, Marco
  • Conde-Ruiz, José Ignacio
  • Desmet, Klaus

We analyse risk-sharing and endogenous fiscal spending in a two-region model with sequentially complete markets. Fiscal policy is determined by majority voting. When policy setting is decentralized, regions choose pro-cyclical fiscal spending in an attempt to manipulate security prices to their benefit. This leads to incomplete risk-sharing, despite the existence of complete markets and the absence of aggregate risk. When a fiscal union centralizes fiscal policy, security prices can no longer be manipulated and complete risk sharing ensues. If regions are relatively homogeneous, median income residents of both regions prefer the fiscal union. If they are relatively heterogeneous, the median resident of the rich region prefers the decentralized setting.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3866.

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Date of creation: Apr 2003
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Handle: RePEc:cpr:ceprdp:3866
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