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Asset Prices, Business Cycles, and Markov-Perfect Fiscal Policy when Agents are Risk-Sensitive

  • Richard Dennis

We study a business cycle model in which a benevolent fiscal authority must determine the optimal provision of government services, while lacking credibility, lump-sum taxes, and the ability to bond finance deficits. Households and the fiscal authority have risk sensitive preferences. We find that outcomes are affected importantly by the household’s risk sensitivity, but not by the fiscal authority’s. Further, while household risk-sensitivity induces a strong precautionary saving motive, which raises capital and lowers the return on assets, its effects on fluctuations and the business cycle are generally small, although more pronounced for negative shocks. Holding the stochastic steady state constant, increases in household risk-sensitivity lower the risk-free rate and raise the return on equity, increasing the equity premium. Finally, although risk-sensitivity has little effect on the provision of government services, it does cause the fiscal authority to lower the income tax rate. An additional contribution of this paper is to present a method for computing Markov-perfect equilibria in models where private agents and the government are risk-sensitive decision makers.

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Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2013-69.

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Length: 29 pages
Date of creation: Oct 2013
Date of revision:
Handle: RePEc:een:camaaa:2013-69
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