Fiscal limits in developing countries: A DSGE Approach

• Published in: Journal of macroeconomics Vol. 49; pp. 119 - 130
• Main Authors: Bi, Huixin, Shen, Wenyi, Yang, Shu-Chun S.
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier Inc 01.09.2016; Elsevier Science Ltd
• Subjects: Deficit financing; Developing countries; DSGE models; Equilibrium; Exchange rates; External debt; Fiscal limits; Fiscal policy; Foreign exchange rates; LDCs; Macroeconomics; Studies; DSGE models; E62; H60; Fiscal limits; H30; Developing countries; External debt
• ISSN: 0164-0704; 1873-152X
• DOI: 10.1016/j.jmacro.2016.06.002

•This paper studies factors that shape fiscal limit distributions in developing countries using a two-sector dynamic stochastic general equilibrium model.•The model incorporates important economic and fiscal policy shocks and fits the Argentina’s post-default data.•Low effective tax rates explain the low fiscal limits in developing countries compared to developed countries.•A large devaluation can turn a sustainable fiscal position into an unsustainable one in an economy that relies heavily on external borrowing. This paper studies fiscal limits in developing countries using a dynamic stochastic general equilibrium (DSGE) approach. Distributions of fiscal limits, which measure a government’s capacity to service its debt, are simulated based on macroeconomic uncertainty and fiscal policy. The analysis shows that expected future revenue plays an important role in explaining the low fiscal limits of developing countries, relative to those of developed countries. Large devaluation of real exchange rates can significantly reduce a government’s capacity to service its debt and lower the fiscal limits. Temporary disturbances, therefore, can shift the distribution of fiscal limits and suddenly change perceptions about fiscal sustainability.