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Essays on the Effects of Macroeconomic Volatility Open Access

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This dissertation consists of three essays of how macroeconomic fluctuations affect the welfare and financial deepening, evaluating the cyclical response of fiscal policy from the expenditure side. The first chapter analyzes the welfare cost of macroeconomic (real) volatility in term of the equivalent variation of per-capita annual consumption for developed countries and one representative developing region (Latin America). In an influential set of lectures, Lucas argues that the welfare cost associated with the business cycle in United States has been negligible in the post-WWII era. As a corollary of his fin ding, more countercyclical policies, than those already applied, would be unnecessary. Although most developing countries register higher macroeconomic volatility in terms of GDP and consumption per capita, there are few studies that estimate and compare the welfare consequences of real volatility in these economies. Starting with the Lucas framework, I provide a quantitative assessment of the welfare cost of macroeconomic fluctuations for developed and Latin American countries. Two alternative models are evaluated across countries: the first one allows for a stochastic trend in the consumption process, while the second one is a general equilibrium model with uninsurable idiosyncratic labor risk. Through the second alternative specification, I find non-negligible welfare costs of more than two-order of magnitude higher than those estimated with the Lucas model. Since the high macroeconomic volatility is a well-known phenomenon in most developing countries, many empirical and theoretical works identify the shallow financial system as the source of output volatility, resulting in inefficient risk-sharing and credit misallocation. Other studies, however, emphasize that patterns of production and the lack of technological diversification are responsible for the high and persistent volatility, but without considering that volatility originating in the real sector may hinder the development of financial system. To explore this possible interaction, in Chapter 2, I develop a general equilibrium framework to explain the channels through which high and persistent macroeconomic volatility can affect financial deepening, by focusing on the exogenous shocks from the real sector. I find that the volatility of total factor productivity (TFP) shocks does not translate one-to-one to a change in output volatility, because of adjustments to investment in capital accumulation induced by changes in the risk premium. This response of the risk premium to TFP shocks explains why real volatility can hinder financial deepening. Consequently, a reduction in the aggregate volatility may increase the country's financial deepening. From this perspective, a shallow financial system can thus be a by-product of the high and persistent macroeconomic volatility. Promoting more resilient output sectors requires time and resources, in the meantime, policy makers should focus on reducing macroeconomic fluctuations to trigger its beneficial effects on financial development. Given the policy challenges, in Chapter 3, the cyclical properties of government expenditures are assessed in both developing and industrial countries for the period 1970-2014. In most developing regions, fiscal policy, from the expenditure side, has been mainly procyclical during the period, while acylical or countercyclical in industrial countries. However, it is possible to identify a breaking point (year) after which the fiscal policy has become more acyclical, or even countercyclical. For developing Asia this year is 1999, while 2002 and 2005 for Sub-Saharan-African and Latin American countries respectively. Asymmetric behaviors of fiscal policy are also registered during the business cycle in all regions. Finally, there is evidence that fiscal policy tends to be more procyclical with low financial openness and acyclical the higher is the access to external borrowing.

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