Derivatives, Fiscal Policy and Financial Stability
ICFAI Journal of Derivatives, Vol. 2, No. 3, pp. 7-25, 2005
25 Pages Posted: 14 Jul 2006
The massive use of derivatives and securitisation by sovereign States for public debt and deficit management is a growing phenomenon in financial markets. Financial innovation can modify risks effectively run and alter the stability of the public sector finance. The experience of some developed and developing countries is surveyed to look at main instruments used and aims of public finance. Financial stability of the public sector is analysed considering financial innovation use. The case of Italy and its scarce disclosure of information are presented. An IS-LM model is used to capture the effect of financial innovation on fiscal policy for high indebted (European) industrialised countries, with deficit constraints, starting from Blanchard (1981). The use of financial innovation can have various effects over debt and deficit management, given binding external burden (like the European criteria) as far as risks are properly considered, expectations of fiscal policy are coherent with that of markets, and no exogenous shock occurs.
Keywords: fiscal policy, financial stability, derivatives and securitisation
JEL Classification: H8, G2, G3, G19
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