Fiscal austerity and informality: Twin deficits as a cushion in Latin American countries

Khalil Bechchani

Economics Letters, 2025, vol. 246, issue C

Abstract: This paper uncovers a new transmission channel that explains the muted effects of fiscal policy in economies with high levels of informality. Using a novel dataset on fiscal consolidations in 14 Latin American and Caribbean countries (1989–2016), I provide evidence supporting the twin deficits hypothesis in highly informal economies. Real exchange rate depreciation and improvements in the current account balance help cushion the negative impacts of fiscal consolidation. In contrast, in economies with smaller informal sectors, this mitigating effect is absent, leading to significant output contractions as a result of austerity. These findings shed new light on how informality shapes the macroeconomic consequences of fiscal policy, offering valuable insights for policymakers in emerging and developing countries.

Keywords: Fiscal Consolidation; Twin Deficits; Informality; Local Projection (search for similar items in EconPapers)
JEL-codes: E26 E32 E62 H5 O17 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecolet:v:246:y:2025:i:c:s0165176524005536

DOI: 10.1016/j.econlet.2024.112069

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