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Aggregate demand management with multiple equilibria

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  • Huberto M. Ennis
  • Todd Keister

Abstract

We study optimal government policy in an economy where (i) search frictions create a coordination problem and generate multiple Pareto-ranked equilibria and (ii). The government finances the provision of a public good by taxing trade. The government must choose the tax rate before it knows which equilibrium will obtain, and therefore an important part of the problem is determining how the policy will affect the equilibrium selection process. We show that when the equilibrium selection rule is based on the concept of risk dominance, higher tax rates make coordination on the Pareto-superior outcome less likely. As a result, taking equilibrium-selection effects into account leads to a lower optimal tax rate. We also show that public-employment policies that appear to be inefficient based on a standard equilibrium analysis may be justifiable if they influence the equilibrium selection process.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 03-04.

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Date of creation: 2003
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Handle: RePEc:fip:fedrwp:03-04

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Keywords: Equilibrium (Economics);

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  1. Woodford, Michael, 1986. "Stationary sunspot equilibria in a finance constrained economy," Journal of Economic Theory, Elsevier, vol. 40(1), pages 128-137, October.
  2. Carlsson, H. & Damme, E.E.C. van, 1990. "Global games and equilibrium selection," Discussion Paper 1990-52, Tilburg University, Center for Economic Research.
  3. Keister, Todd, 1998. "Money Taxes and Efficiency When Sunspots Matter," Journal of Economic Theory, Elsevier, vol. 83(1), pages 43-68, November.
  4. Smith, B.D., 1988. "Interest On Reserves And Sunspot Equilibria: Friedman'S Proposal Reconsidered," RCER Working Papers 119, University of Rochester - Center for Economic Research (RCER).
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  8. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
  9. Grandmont Jean-michel, 1985. "Stabilizing competitive business cycles," CEPREMAP Working Papers (Couverture Orange) 8518, CEPREMAP.
  10. S. Morris & R. Rob & H. Shin, 2010. "p-dominance and Belief Potential," Levine's Working Paper Archive 505, David K. Levine.
  11. Satyajit Chatterjee & Dean Corbae, 2000. "On the welfare gains of reducing the likelihood of economic crises," Working Paper 0015, Federal Reserve Bank of Cleveland.
  12. Howitt, Peter & McAfee, R Preston, 1992. "Animal Spirits," American Economic Review, American Economic Association, vol. 82(3), pages 493-507, June.
  13. Diamond, Peter A, 1982. "Aggregate Demand Management in Search Equilibrium," Journal of Political Economy, University of Chicago Press, vol. 90(5), pages 881-94, October.
  14. Cooper, Russell & John, Andrew, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 441-63, August.
  15. John C. Harsanyi & Reinhard Selten, 1988. "A General Theory of Equilibrium Selection in Games," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262582384, December.
  16. Reichlin, Pietro, 1986. "Equilibrium cycles in an overlapping generations economy with production," Journal of Economic Theory, Elsevier, vol. 40(1), pages 89-102, October.
  17. Ricardo Lagos, 2000. "An Alternative Approach to Search Frictions," Journal of Political Economy, University of Chicago Press, vol. 108(5), pages 851-873, October.
  18. Van Huyck, John B & Battalio, Raymond C & Beil, Richard O, 1991. "Strategic Uncertainty, Equilibrium Selection, and Coordination Failure in Average Opinion Games," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 885-910, August.
  19. Huberto M. Ennis & Todd Keister, 2003. "Government Policy and the Probability of Coordination Failures," Working Papers 0301, Centro de Investigacion Economica, ITAM.
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Cited by:
  1. Ennis, Huberto M. & Keister, Todd, 2005. "Government policy and the probability of coordination failures," European Economic Review, Elsevier, vol. 49(4), pages 939-973, May.
  2. Ennis, Huberto M. & Keister, Todd, 2005. "Optimal fiscal policy under multiple equilibria," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1359-1377, November.

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