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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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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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