This paper studies an optimal fiscal policy problem of Lucas and Stokey (1983) but in a situation in which the representative agent's distrust of the probability model for government expenditures puts model uncertainty premia into history-contingent prices. This situation gives rise to a motive for expectation management that is absent within rational expectations and a novel incentive for the planner to smooth the shadow value of the agent's subjective beliefs to manipulate the equilibrium price of government debt. Unlike the Lucas and Stokey (1983) model, the optimal allocation, tax rate, and debt become history dependent despite complete markets and Markov government expenditures.
JEL classification: D80, E62, H21, H63
Key words: Ramsey plan, misspecification, robustness, taxes, debt, martingale, expansion
This paper circulated previously under the title “Ramsey Taxation and Fear of Misspecification” and was first drafted in November 2007. The authors thank David Backus, Marco Bassetto, Pierpaolo Benigno, Marco Cagetti, Steve Coate, Kris Gerardi, Ricardo Lagos, Andreas Lehnert, Guido Lorenzoni, Jim Nason, Monika Piazzesi, Will Roberds, John Rust, Martin Schneider, John Shea, Karl Shell, Ennio Stacchetti, Tom Tallarini, Viktor Tsyrennikov, Tao Zha, and seminar participants at Birkbeck College, Cornell University, Einaudi Institute for Economics and Finance, the Federal Reserve Board of Governors, the Federal Reserve Banks of Atlanta and Chicago, the University of Iowa, the University of Maryland, New York University, the University of Oxford, Penn State University, the University of Warwick, and the Wharton School. Anastasios Karantounias thanks without implicating the Research and Statistics Division of the Federal Reserve Board and the Monetary Policy Strategy Division of the European Central Bank for their hospitality and support. Thomas Sargent's research was supported by a grant to the National Bureau of Economic Research from the National Science Foundation. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author's responsibility.
Please address questions regarding content to Anastasios Karantounias (corresponding author), Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309-4470, 404-498-8825, anastasios.karantounias@atl.frb.org; Lars Peter Hansen, Department of Economics, University of Chicago, 1126 East 59th Street, Chicago, IL 60637, 773-702-8170, l-hansen@uchicago.edu; or Tom Sargent, Department of Economics, New York University and Hoover Institution, 19 W. Fourth Street, New York, NY 10012-1119, 212-998-3548, thomas.sargent@nyu.edu.
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