Public Finance under Political Instability and Debt Conditionality

This paper presents an intertemporal political economy model of sustainable public finance relevant for many developing or transition countries: instability is inherent to the political structure and foreign debt is a crucial source of government revenue. The main results are: First, political instability causes myopic government behaviour as it induces higher debt levels, but it does not lead to an increase in inflation taxation as in Cukierman, et al. (1992). Second, debt conditionality aiming at monetary stability is particularly effective in heterogeneous societies with unstable governments. Third, it is shown that IMF policies requiring debtor countries to achieve both monetary and fiscal stability are suboptimal.