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Risk Aversion and Recessive Impacts of Austerity

Vaz de Castro, Afonso (2022): Risk Aversion and Recessive Impacts of Austerity.

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Abstract

This paper aims to contribute for the vast literature on the impact of country-specific characteristics on fiscal multipliers. We argue that countries have relevant differences in risk attitudes, and that those differences are economically significant in determining output responses to fiscal consolidation programs. We start with an empirical analysis, estimating the coefficient of relative risk aversion for nine European economies, finding relevant heterogeneity across countries. Using the coefficients found, we calibrate an incomplete markets overlapping generations model and study the impacts of an unanticipated fiscal consolidation shock. We find a positive relationship between fiscal multipliers and risk aversion when there is a spending-based consolidation, showing that recessive impacts from austerity are stronger the larger the degree of risk aversion. The underlying mechanism depends on the effect of risk aversion on precautionary savings behavior and so on the share of constrained agents. Larger risk aversion induces more precautionary savings, thus shrinking the share of constrained agents. Credit-constrained agents have a less responsive labor supply with respect to spending-based fiscal consolidation shocks.

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