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Fiscal Policy and Macroeconomic Uncertainty in Emerging Markets: The Tale of the Tormented Insurer

  • Enrique G. Mendoza

    ()

    (University of Maryland)

  • P. Marcelo Oviedo

Governments in emerging markets often behave like a "tormented insurer", trying to use non-state-contingent debt instruments to avoid sharp adjustments in their payments to private agents despite sharp fluctuations in public revenues. In the data, their ability to sustain debt is inversely related to the variability of their revenues, and their primary balances and current expenditures follow a procyclical pattern that contrasts sharply with the evidence from industrial countries. This paper proposes an equilibrium model of a small open economy with incomplete markets and aggregate uncertainty that can rationalize this behavior. In the model, a fiscal authority that chooses optimal expenditure and debt plans given stochastic revenues interacts with private agents that also make optimal consumption and asset accumulation plans. The competitive equilibrium of this economy is solved numerically as a Markov perfect equilibrium using parameter values calibrated to Mexican data. If perfect domestic risk pooling were possible, the ratio of public-to-private expenditures would be constant. With incomplete markets, however, this ratio fluctuates widely and results in welfare losses that dwarf previous estimates of the benefits of risk sharing and consumption smoothing. The model also yields a negative relationship between average public debt and revenue variability similar to the one observed in the data, and a correlation between output and government purchases that matches Mexican data

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Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 377.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:377
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  1. 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.
  2. Bennett Sutton & Luis Catão, 2002. "Sovereign Defaults; The Role of Volatility," IMF Working Papers 02/149, International Monetary Fund.
  3. Graciela L. Kaminsky & Carmen M. Reinhart & Carlos A. Végh, 2005. "When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies," NBER Chapters, in: NBER Macroeconomics Annual 2004, Volume 19, pages 11-82 National Bureau of Economic Research, Inc.
  4. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
  5. Oya Celasun & Xavier Debrun & Jonathan D. Ostry, 2006. "Primary Surplus Behavior and Risks to Fiscal Sustainability in Emerging Market Countries: A "Fan-Chart" Approach," IMF Staff Papers, Palgrave Macmillan, vol. 53(3), pages 3.
  6. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August.
  7. Lucas, Robert E, Jr, 1996. "Nobel Lecture: Monetary Neutrality," Journal of Political Economy, University of Chicago Press, vol. 104(4), pages 661-82, August.
  8. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  9. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, vol. 59(2), pages 371-96, March.
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