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Markov-perfect optimal fiscal policy : the case of unbalanced budgets

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2012-10-29
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We study optimal time-consistent fiscal policy in a neoclassical economy with endogenous government spending, physical capital and public debt. We show that a dynamic complementarity between the households’ consumption-savings decision and the government’s policy decision gives rise to a multiplicity of expectations-driven Markov-perfect equilibria. The long-run levels of taxes, government spending and debt are not uniquely pinned down by economic fundamentals, but are determined by expectations over current and future policies. Accordingly, economies with identical fundamentals may significantly differ in their levels of public indebtedness
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Optimal fiscal policy, Markov-perfect equilibrium, Time-consistent policy, Expectation traps
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