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Optimal fiscal policy with robust control

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  • Svec, Justin

Abstract

This paper analyzes how consumer uncertainty affects optimal fiscal policy in the Lucas and Stokey (1983) framework. The consumers, lacking confidence in their knowledge of the stochastic environment, endogenously tilt their subjective probability model away from an approximating probability model. The government, though, is confident that the approximating probability model characterizes the stochastic environment. This confidence dichotomy reveals a range of possible objective functions for an altruistic government. I assume that the government maximizes the consumers' expected utility under the consumers' own subjective probability model. It is found that this government relies less heavily on labor taxes to absorb the fiscal shock than would be optimal if consumers were fully confident in their probability model. This policy helps mitigate the direct welfare cost associated with consumer uncertainty. I compare this policy to the one implemented by a government that maximizes the consumers' expected utility under the approximating probability model.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 36 (2012)
Issue (Month): 3 ()
Pages: 349-368

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Handle: RePEc:eee:dyncon:v:36:y:2012:i:3:p:349-368

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Web page: http://www.elsevier.com/locate/jedc

Related research

Keywords: Robust control; Uncertainty; Taxes; Debt;

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References

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  1. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Fiscal and Monetary Policy in an Economy Without Capital," Discussion Papers 532, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  2. Richard Dennis & Kai Leitemo & Ulf Soderstrom, 2006. "Methods for Robust Control," 2006 Meeting Papers 493, Society for Economic Dynamics.
  3. Richard Dennis, 2007. "Model uncertainty and monetary policy," Working Paper Series 2007-09, Federal Reserve Bank of San Francisco.
  4. Ryan Chahrour & Justin Svec, 2014. "Optimal Capital Taxation and Consumer Uncertainty," Working Papers 1108, College of the Holy Cross, Department of Economics.
  5. Hansen, Lars Peter & Sargent, Thomas J., 2005. "Recursive robust estimation and control without commitment," Discussion Paper Series 1: Economic Studies 2005,28, Deutsche Bundesbank, Research Centre.
  6. Narayana Kocherlakota & Christopher Phelan, 2007. "On the Robustness of Laissez-Faire," Levine's Bibliography 843644000000000165, UCLA Department of Economics.
  7. Marcet, A. & Marimon, R., 1998. "Recursive Contracts," Economics Working Papers eco98/37, European University Institute.
  8. Camerer, Colin & Weber, Martin, 1992. " Recent Developments in Modeling Preferences: Uncertainty and Ambiguity," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 325-70, October.
  9. Anastasios G. Karantounias with Lars Peter Hansen & Thomas J. Sargent, 2009. "Managing expectations and fiscal policy," Working Paper 2009-29, Federal Reserve Bank of Atlanta.
  10. Michael Woodford, 2005. "Robustly Optimal Monetary Policy with Near Rational Expectations," NBER Working Papers 11896, National Bureau of Economic Research, Inc.
  11. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1993. "Optimal fiscal policy in a business cycle model," Staff Report 160, Federal Reserve Bank of Minneapolis.
  12. Hansen, Lars Peter & Sargent, Thomas J. & Turmuhambetova, Gauhar & Williams, Noah, 2006. "Robust control and model misspecification," Journal of Economic Theory, Elsevier, vol. 128(1), pages 45-90, May.
  13. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
  14. Hansen, Lars Peter & Sargent, Thomas J., 2005. "Robust estimation and control under commitment," Journal of Economic Theory, Elsevier, vol. 124(2), pages 258-301, October.
  15. Orphanides, Athanasios & Williams, John C., 2007. "Robust monetary policy with imperfect knowledge," Journal of Monetary Economics, Elsevier, vol. 54(5), pages 1406-1435, July.
  16. Dennis, Richard, 2010. "How robustness can lower the cost of discretion," Journal of Monetary Economics, Elsevier, vol. 57(6), pages 653-667, September.
  17. Thomas J. Sargent & LarsPeter Hansen, 2001. "Robust Control and Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 60-66, May.
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Citations

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Cited by:
  1. Richard Dennis, 2013. "Asset Prices, Business Cycles, and Markov-Perfect Fiscal Policy when Agents are Risk-Sensitive," Working Papers 2013_15, Business School - Economics, University of Glasgow.
  2. Michael Woodford, 2005. "Robustly optimal monetary policy with near-rational expectations," Discussion Papers 0506-13, Columbia University, Department of Economics.
  3. Konstantinos Angelopoulos & George Economides & Apostolis Philippopoulos, 2012. "Public Good Provision with Robust Decision Making," CESifo Working Paper Series 3996, CESifo Group Munich.
  4. Ryan Chahrour & Justin Svec, 2014. "Optimal Capital Taxation and Consumer Uncertainty," Boston College Working Papers in Economics 854, Boston College Department of Economics.
  5. Joshua Congdon-Hohman & Anil Nathan & Justin Svec, 2013. "Student Uncertainty and Major Choice," Working Papers 1301, College of the Holy Cross, Department of Economics.
  6. Robert Baumann & Justin Svec, 2013. "The Impact of Political Uncertainty: A Robust Control Approach," Working Papers 1306, College of the Holy Cross, Department of Economics.
  7. Young, Eric R., 2012. "Robust policymaking in the face of sudden stops," Journal of Monetary Economics, Elsevier, vol. 59(5), pages 512-527.

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