Fiscal Cyclicality and Market Incompleteness

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• OVERVIEW
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• To explain the puzzle that fiscal policy is often procyclical in emerging and developing countries (i.e., fiscal policy is expansionary in good times and contractionary in bad times), we develop a model for the optimal behavior of government spending and tax rates over the business cycle. Our set-up relies on financial frictions, which have been shown to be critical features of emerging markets, captured by various degrees of asset market incompleteness as well as varying levels of debt elasticities of real interest rates. We first uncover a novel theoretical result within a simple static framework: incomplete markets can explain procyclical government spending but not necessarily procycical tax policy. Proyclical tax policy requires that the ratio of private to public consumption comoves positively with the business cycle. The procyclicality of tax policy holds in a more realistic, dynamic, general equilibrium model calibrated to emerging markets. Further, we show how larger financial frictions, which amplify the business cycle through more procyclical fiscal policies, have sizeable welfare costs.

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• Carlos A. Vegh is the Fred H. Sanderson Professor of International Economics at Johns Hopkins University, where he is jointly appointed in the School of Advanced International Studies (SAIS) in Washington, DC and the Department of Economics in the Zanvyl Krieger School of Arts and Sciences (KSAS) in Baltimore. He was the World Bank Chief Economist for Latin America and the Caribbean in 2017-2019. He is a Research Associate at the National Bureau of Economic Research (NBER) and was a Non-Resident Senior Fellow at the Brookings Institution. He has published extensively in leading academic journals on monetary and fiscal policy in developing and emerging countries, and is the author of a graduate textbook on open economy macroeconomics for developing countries (MIT Press). He has been a consultant for the IMF, World Bank, IDB, and policy institutions around the world.