Imperfect financial markets and the cyclicality of social spending

Maren Froemel and Wojtek Paczos

European Economic Review, 2024, vol. 167, issue C

Abstract: This paper explores the link between default risk and fiscal procyclicality. We show that countries with higher sovereign risk have a more procyclical fiscal expenditure policy, which is driven mostly by transfers. We build a small open economy model with income inequality, social transfers, and default risk to rationalize this fact. Without default risk transfers are countercyclical, inequality is procyclical, and external debt is used to smooth distortionary taxation. With default risk, transfers account for most of fiscal adjustment because taxation becomes costly for the government. Transfers become procyclical and inequality worsens during times when risk premia are high. We confirm the predictions of the model in the data: in recessions in economies with default risk, transfers take the bigger burden relative to government consumption, whereas the opposite is true in economies with low default risk.

Keywords: Fiscal policy; Default risk; Income inequality; Redistribution; Emerging markets (search for similar items in EconPapers)
JEL-codes: E62 F34 F41 (search for similar items in EconPapers)
Date: 2024
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Citations: View citations in EconPapers (1)

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Working Paper: Imperfect Financial Markets and the Cyclicality of Social Spending (2024)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:eecrev:v:167:y:2024:i:c:s0014292124001156

DOI: 10.1016/j.euroecorev.2024.104786

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