Endogenous Policy Leads to Inefficient Risk Sharing

Marco Celentani, J. Ignacio Conde-Ruiz and Klaus Desmet

No 2003-08, Working Papers from FEDEA

Abstract: We analyse risk sharing and endogenous fiscal spending in a two-region model with sequentially complete markets. Fiscal policy is determined by majority voting. When policy setting is decentralized, regions choose pro-cyclical fiscal spending in an attempt to manipulate security prices to their benefit. 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, security prices can no longer be manipulated and complete risk sharing ensues. If regions are relatively homogeneous, median income residents of both regions prefer the fiscal union. If they are relatively heterogeneous, the median resident of the rich region prefers the decentralized setting.

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Journal Article: Endogenous Policy Leads to Inefficient Risk Sharing (2004)
Working Paper: Endogenous Policy Leads to Inefficient Risk-Sharing (2003)
Working Paper: Endogenous policy leads to inefficient risk sharing (2003)
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