Fiscal Policy and Financial Depth

22 Pages Posted: 20 May 2004

See all articles by Ricardo J. Caballero

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Arvind Krishnamurthy

Northwestern University - Kellogg School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: May 3, 2004

Abstract

Most economists and observers place the lack of fiscal discipline at the core of the recent Argentine crisis. This begs the question of how countries like Belgium or Italy (pre-Maastricht) could run large fiscal deficits and accumulate debts far beyond those of Argentina, without experiencing crises nearly as dramatic as that of Argentina. Why is it that Argentina cannot act like Belgium or Italy and pursue expansionary fiscal policy during downturns? We argue that advanced and emerging economies differ in their financial depth, and show that lack of financial depth constrains fiscal policy in a way that can overturn standard Keynesian fiscal policy prescriptions. We also provide empirical support for this viewpoint. Crowding out is systematically larger in emerging markets than in developed economies. More importantly, this difference is extreme during crises, when the crowding out coefficient exceeds one in emerging market economies.

Keywords: sudden stops, financial depth, fiscal deficits, liquidity crises, populism, crowding out

JEL Classification: E44, E62, F34, F41

Suggested Citation

Caballero, Ricardo J. and Krishnamurthy, Arvind, Fiscal Policy and Financial Depth (May 3, 2004). Available at SSRN: https://ssrn.com/abstract=548384 or http://dx.doi.org/10.2139/ssrn.548384

Ricardo J. Caballero (Contact Author)

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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Arvind Krishnamurthy

Northwestern University - Kellogg School of Management ( email )

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