Endogenous Policy Leads to Inefficient Risk Sharing
UPF Economics and Business Working Paper No. 593
33 Pages Posted: 18 Jul 2003
Date Written: March 2003
We analyze risk sharing and fiscal spending in a two-region model with sequentially complete markets. Fiscal policy is determined by majority voting. When policy setting is decentralized, regions choose pro-cyclical fiscal spending in an attempt to manipulate security prices to their benefit. This leads to incomplete risk sharing, despite the existence of complete markets and the absence of aggregate risk. When a fiscal union centralizes fiscal policy, securities prices can no longer be manipulated and complete risk sharing ensues. If regions are relatively homogeneous, the median income resident of the rich region prefers the decentralized setting.
Keywords: Endogenous policy, complete markets, efficiency, risk sharing
JEL Classification: C72, D50, D72, E61
Suggested Citation: Suggested Citation