On the Efficiency-Effects of Private (Dis-)Trust in the Government

We consider a continuous-time version of Ireland's Neo-Keynesian reinterpretation of the seminal Kydland-Prescott model, assuming now an heterogenous private sector. In each period, a fraction of the private agents naively believes the policy announcements made by the government. The other agents, who know the current number of non-believers in the economy, are utility-maximizers. The fraction of agents who believe the government changes over time according to a Word of Mouth learning process, that depends upon the difference between the payoffs they obtain and the payoffs realized by the non-believers. The government minimizes its cumulated loss through its choice of policy announcement and realized policy. We show that the economy can have two stable equilibria. At one of these, all agents act rationally. At the other equilibrium, which is associated with a higher average utility of the private sector, a positive percentage of the agents trusts the government. The two equilibria are separated by a Skiba point associated with an unstable spiral of the canonical system. Thus, the initial fraction of believers in the economy can have drastic consequences for the economic policy followed and the losses experienced by the different agents. Moreover, the flexibility of the private sector in reacting to the losses' difference proves to be crucial. Independently of the number of believers in the economy, the government losses monotonically increase with the flexibility. The private sector, on the other hand, is best off for an intermediate level of flexibility.