Paper #593

Title:

Endogenous policy leads to inefficient risk sharing

Authors:

Marco Celentani, J. Ignacio Conde and Klaus Desmet

Date:

January 2002 (Revised: March 2003)

Abstract:

We analyze risk sharing and fiscal spending in a two-region model with complete markets. Fiscal policy determines tax rates for each state of nature. When fiscal policy is decentralized, it can be used to affect prices of securities. To manipulate prices to their beneffit, regions choose pro-cyclical fiscal spending. 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 homogeneous, median income residents of both regions prefer the fiscal union. If they are heterogeneous, the median resident of the rich region prefers the decentralized setting.

Keywords:

Interregional risk-sharing, complete markets

JEL codes:

C72, D50, D72, E61

Area of Research:

Microeconomics

Published in:

Review of Economic Dynamics, Vol. 7(3), pp 758-787, 2004

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