Working Paper: CEPR ID: DP3866
Authors: Marco Celentani; Jos Ignacio Conderuiz; Klaus Desmet
Abstract: 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.
Keywords: Complete Markets; Efficiency; Endogenous Policy; Risk-Sharing
JEL Codes: C72; D50; D72; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Decentralized fiscal policy (H77) | Incomplete risk-sharing (D81) |
| Pro-cyclical fiscal spending (E62) | Incomplete risk-sharing (D81) |
| Centralized fiscal policy (E62) | Complete risk-sharing (D81) |
| Regional characteristics (R11) | Preferences for policy structures (D78) |