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Commodity price risk management and fiscal policy in a sovereign default model

Commodity prices are an important driver of the behavior of fiscal policy and the business cycle in commodity exporting developing and emerging market economies. Among other factors, these results have been attributed to the fact that governments in many economies rely to an important extent on commodity revenues to finance their budgets. For example, in more than twenty countries hydrocarbon revenues account for over thirty percent of total fiscal revenue (IMF, 2007). Given their reliance on a highly volatile source of revenue, these economies face a significant challenge in terms of their capacity to smooth fiscal policy and fluctuations in economic activity. Different instruments have been proposed and implemented with the purpose of moderating the impact of commodity-price fluctuations on public finances. In this article we exploit a dynamic model of sovereign default with endogenous fiscal policy, introducing a stochastic endowment of commodity-revenues for the government, to contribute to our understanding of the potential macroeconomic consequences of using these instruments. This model is a natural framework to illustrate the tradeoffs faced by a government subject to significant fluctuations in commodity-related revenues as it endogeneizes the decisions of public expenditures, distortionary tax rates, the issuance of debt and the default of sovereign debt. Furthermore, it allows us to do so in a relatively standard business cycle environment.