Fiscal policy and default risk in emerging markets,☆☆

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Abstract

Emerging market economies typically exhibit a procyclical fiscal policy: public expenditures rise (fall) in economic expansions (recessions), whereas tax rates rise (fall) in bad (good) times. Additionally, the business cycle of these economies is characterized by countercyclical default risk. In this paper we develop a quantitative dynamic stochastic small open economy model with incomplete markets, endogenous fiscal policy and sovereign default where public expenditures and tax rates are optimally procyclical. The model also accounts for the dynamics of other key macroeconomic variables in emerging economies.

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    For useful comments, we thank seminar participants at the Board of Governors of the Federal Reserve System, the Banco de México, the 2006 North American Summer Meeting of the Econometric Society, the 2006 Society of Economic Dynamics Meeting, the 2006 LACEA Meeting, the 2006 Wegmans Conference at the University of Rochester and the 2008 Macroeconomics of Emerging Countries Conference.

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    The views expressed in this paper are those of the authors, and do not necessarily reflect those of the Federal Reserve Bank of Richmond or the Federal Reserve System.

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