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Fiscal Policy and Financial Markets*

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     The views expressed in this article are those of the author(s) and do not represent those of the IMF or IMF policy. This article was written when Thomas Stratmann was a visiting scholar with the IMF's Fiscal Affairs Department in early 2005. Thomas Stratmann thanks the Earhart Foundation for financial support. We thank Larry Cui for the excellent research support. We thank the editor and two anonymous referees, Gerd Schwartz, Antonio Spilimbergo, Robert Flood, David Hauner and Anna Ilyina for very helpful comments and suggestions. We are also grateful for helpful suggestions by participants of the conference on ‘New Perspectives on Fiscal Sustainability’ held at Goethe Universität Frankfurt, in October 2005.

Abstract

We examine the effect of fiscal policy on sovereign risk spreads and investigate whether the interaction of fiscal variables with political institutions affect financial markets. Using panel data from emerging market countries, we find that revenue-based adjustment lowers spreads more than spending-based adjustment. Financial markets also react to the composition of spending. Cuts in current spending lower spreads more than cuts in investment. We show that debt-financed spending increases sovereign risk, while tax-financed spending lowers spreads, suggesting that international investors prefer the latter. Further, we find evidence that financial markets’ reaction to fiscal policy depends on political institutions.

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