Fiscal Policy and Financial Depth

22 Pages Posted: 11 Jun 2004 Last revised: 13 Oct 2022

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 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.

Suggested Citation

Caballero, Ricardo J. and Krishnamurthy, Arvind, Fiscal Policy and Financial Depth (May 2004). NBER Working Paper No. w10532, Available at SSRN: https://ssrn.com/abstract=552895

Ricardo J. Caballero (Contact Author)

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Arvind Krishnamurthy

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