Axelle Ferrière and Anastasios G. Karantounias
Working Paper 2016-6a
March 2016 (revised January 2018)
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This paper analyzes optimal fiscal policy with ambiguity aversion and endogenous government spending. We show that, without ambiguity, optimal surplus-to-output ratios are acyclical and that there is no rationale for either reduction or further accumulation of public debt. In contrast, ambiguity about the cycle can generate optimally policies that resemble "austerity" measures. Optimal policy prescribes higher taxes in adverse times and front-loaded fiscal consolidations that lead to a balanced primary budget in the long-run. This is the case when interest rates are sufficiently responsive to cyclical shocks—that is, when the intertemporal elasticity of substitution is sufficiently low.
JEL classification: D80, E62, H21, H63
Key words: public consumption, intertemporal elasticity of substitution, balanced budget, austerity, fiscal consolidation, ambiguity aversion, multiplier preferences
The authors thank David Backus, Richard Rogerson, Thomas J. Sargent, Stanley E. Zin for their support of this project and Mikhail Golosov for his discussion. They are grateful to the editor and to three anonymous referees for insightful comments. They also thank Roc Armenter, Anmol Bhandari, Lukasz Drozd, Murat Tasci, conference participants at the Ambiguity and Robustness Workshops at the Becker Friedman Institute and New York University, the CEF Meetings in Oslo, the 15th Conference on Research on Economic Theory and Econometrics at Tinos, the EEA Meetings in Toulouse, the SED Meetings in Toronto, and seminar participants at the Federal Reserve Banks of Atlanta, Cleveland, and Philadelphia and at Florida International University and Florida State University. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Axelle Ferrière, Department of Economics, European University Institute, Via delle Fontanelle 18, 50014, Fiesole, Italy, axelle.ferriere@eui.eu, or Anastasios G. Karantounias (corresponding author), Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309-4470, 404-498-8825, anastasios.karantounias@atl.frb.org.
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