Policy Gridlock, Budget Rigidities and Sovereign Risk

Budget rigidities are an important element to evaluate fiscal policy. For a sample of emerging markets, different categories of government expenditures are classified as mandatory or discretionary. The share of mandatory spending with respect to total outlays increases around default episodes, reflecting the difficulties of adjusting this type of spending during strong economic contractions. The paper develops a two-party political economy model of fiscal policy and sovereign default, with these two types of government outlays. Parties bargain over the budget, and a unanimous agreement is required to change mandatory spending. Gridlock arises when parties disagree. The model replicates two features of the data, the burden of mandatory spending raises during times of fiscal distress and variations in this type of outlays
are positively correlated with movements in spreads. Also, the introduction of bud-get rigidities reduces the model’s average spreads; but, at the same time, increases their volatility.