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Aggregate demand management with multiple equilibria

  • Huberto M. Ennis
  • Todd Keister

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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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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  17. Huberto M. Ennis & Todd Keister, 2003. "Government Policy and the Probability of Coordination Failures," Working Papers 0301, Centro de Investigacion Economica, ITAM.
  18. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
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