Working Paper: NBER ID: w12586
Authors: Enrique G. Mendoza; P. Marcelo Oviedo
Abstract: Governments in emerging markets often behave like a "tormented insurer," trying to use non-state-contingent debt instruments to avoid cuts in payments to private agents despite large fluctuations in public revenues. In the data, average public debt-GDP ratios decline as the variability of revenues increases, primary balances and current expenditures follow cyclical patterns sharply at odds with the countercyclical patterns of industrial countries, and the cyclical variability of public expenditures exceeds that of private expenditures by a wide margin. This paper proposes a model of a small open economy with incomplete markets that can rationalize this behavior. In the model a fiscal authority makes optimal expenditure and debt plans given shocks to output and revenues, and private agents make optimal consumption and asset accumulation plans. Quantitative analysis of the model calibrated to Mexico yields a negative relationship between average public debt and revenue variability similar to the one observed in the data. The model mimics Mexico's GDP correlations of government purchases and the primary balance. The ratio of public-to-private expenditures fluctuates widely and the implied welfare costs dwarf conventional estimates of negligible benefits of risk sharing and consumption smoothing.
Keywords: Fiscal Policy; Macroeconomic Uncertainty; Developing Countries; Public Debt; Revenue Volatility
JEL Codes: E62; F34; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government revenue volatility (H27) | average public debt (H63) |
| average public debt (H63) | revenue variability (H27) |
| government expenditure variability (H59) | private expenditure variability (D12) |
| fiscal policy behavior (E62) | welfare costs (I30) |