Issues on fiscal policy TaxSmoothing Barro 1979 Romer
![Issues on fiscal policy Issues on fiscal policy](https://slidetodoc.com/presentation_image_h/73f3080834393e40bbbf1d02f39c18ed/image-1.jpg)
Issues on fiscal policy
![Tax-Smoothing (Barro 1979) Romer (2012) section 12. 4 Distortion costs from raising Tt: The Tax-Smoothing (Barro 1979) Romer (2012) section 12. 4 Distortion costs from raising Tt: The](http://slidetodoc.com/presentation_image_h/73f3080834393e40bbbf1d02f39c18ed/image-2.jpg)
Tax-Smoothing (Barro 1979) Romer (2012) section 12. 4 Distortion costs from raising Tt: The government chooses the path that minimizes this distortion:
![Costs are minimized when: This result is very interesting under uncertainty: Costs are minimized when: This result is very interesting under uncertainty:](http://slidetodoc.com/presentation_image_h/73f3080834393e40bbbf1d02f39c18ed/image-3.jpg)
Costs are minimized when: This result is very interesting under uncertainty:
![Discussion: T/Y follows a random walk (no predictable changes in T/Y. 1) Important role Discussion: T/Y follows a random walk (no predictable changes in T/Y. 1) Important role](http://slidetodoc.com/presentation_image_h/73f3080834393e40bbbf1d02f39c18ed/image-4.jpg)
Discussion: T/Y follows a random walk (no predictable changes in T/Y. 1) Important role for debt financing: War 2) Recessions
![Model of debt crisis, Romer 4 th edition section 12. 10 • One period Model of debt crisis, Romer 4 th edition section 12. 10 • One period](http://slidetodoc.com/presentation_image_h/73f3080834393e40bbbf1d02f39c18ed/image-5.jpg)
Model of debt crisis, Romer 4 th edition section 12. 10 • One period model • D debt has to be rolled over (issue D of new debt to pay off the debt coming due) • T tax revenues the following period, • Government want investors to hold the debt for one period • T is random with cumulative function F() • R is the interest factor (1+r) and R-1 is the interest rate r • If T is less than RD full default • Default is all-or-nothing • Investors are risk neutral • The riskless interest factor RMIN is independent of R and D. • π is the expected probability of default
![Arbitrage between risky and riskless assets implies • (1 -π)R = RMIN • Or Arbitrage between risky and riskless assets implies • (1 -π)R = RMIN • Or](http://slidetodoc.com/presentation_image_h/73f3080834393e40bbbf1d02f39c18ed/image-6.jpg)
Arbitrage between risky and riskless assets implies • (1 -π)R = RMIN • Or π = (R-RMIN)/R (12. 42) • Example European debt crisis • 12. 42 is plotted in the following graph
![Condition for investors to be willing to hold government debt From 12. 42 1 Condition for investors to be willing to hold government debt From 12. 42 1](http://slidetodoc.com/presentation_image_h/73f3080834393e40bbbf1d02f39c18ed/image-7.jpg)
Condition for investors to be willing to hold government debt From 12. 42 1 π RMIN R
![Second equilibrium condition: government defaults if T < RD • • • T distribution Second equilibrium condition: government defaults if T < RD • • • T distribution](http://slidetodoc.com/presentation_image_h/73f3080834393e40bbbf1d02f39c18ed/image-8.jpg)
Second equilibrium condition: government defaults if T < RD • • • T distribution function is F() π = F(RD) (12. 43) The maximum value of T is TMAX The minimum value of T is TMIN Density function is bell-shaped The cumulative distribution function is Sshaped
![The probability of default as a function of the interest factor 1 π TMIN/D The probability of default as a function of the interest factor 1 π TMIN/D](http://slidetodoc.com/presentation_image_h/73f3080834393e40bbbf1d02f39c18ed/image-9.jpg)
The probability of default as a function of the interest factor 1 π TMIN/D TMAX/D R
![The determination of the interest factor and the probability of default 1 B π The determination of the interest factor and the probability of default 1 B π](http://slidetodoc.com/presentation_image_h/73f3080834393e40bbbf1d02f39c18ed/image-10.jpg)
The determination of the interest factor and the probability of default 1 B π πA TMIN/D B is unstable (p. 636) Two stable equilibria, A And π=1 A RMIN TMAX/D R
![Analysis • So there are two equilibria, one when the interest factor and the Analysis • So there are two equilibria, one when the interest factor and the](http://slidetodoc.com/presentation_image_h/73f3080834393e40bbbf1d02f39c18ed/image-11.jpg)
Analysis • So there are two equilibria, one when the interest factor and the probability of default are low, one where no investor want to hold the debt • For a sufficiently large riskless rate RMIN (Figure 12. 6 next) the red curve is on the right of the blue curve and the only equilibrium is π=1. You don’t need large change in fundamental to have π moving from a low πA to π=1 • For RMIN below this point, and increase in RMIN increase the low πA • Read page 637 -638 (the conclusion on expectation, beliefs about fundamentals is Keynesian).
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