Asset Prices, Business Cycles, and Markov-Perfect Fiscal Policy when Agents are Risk-Sensitive

Richard Dennis

CAMA Working Papers from Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University

Abstract: We study a business cycle model in which a benevolent fiscal authority must determine the optimal provision of government services, while lacking credibility, lump-sum taxes, and the ability to bond finance deficits. Households and the fiscal authority have risk sensitive preferences. We find that outcomes are affected importantly by the household’s risk sensitivity, but not by the fiscal authority’s. Further, while household risk-sensitivity induces a strong precautionary saving motive, which raises capital and lowers the return on assets, its effects on fluctuations and the business cycle are generally small, although more pronounced for negative shocks. Holding the stochastic steady state constant, increases in household risk-sensitivity lower the risk-free rate and raise the return on equity, increasing the equity premium. Finally, although risk-sensitivity has little effect on the provision of government services, it does cause the fiscal authority to lower the income tax rate. An additional contribution of this paper is to present a method for computing Markov-perfect equilibria in models where private agents and the government are risk-sensitive decision makers.

Keywords: Asset prices; business cycles; risk-sensitivity; Markov-Perfect fiscal policy (search for similar items in EconPapers)
JEL-codes: C61 E63 (search for similar items in EconPapers)
Pages: 29 pages
Date: 2013-10
New Economics Papers: this item is included in nep-dge, nep-mac, nep-ore and nep-pbe
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Related works:
Working Paper: Asset Prices, Business Cycles, and Markov-Perfect Fiscal Policy when Agents are Risk-Sensitive (2013)
Working Paper: Asset Prices, Business Cycles, and Markov-Perfect Fiscal Policy when Agents are Risk-Sensitive (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:een:camaaa:2013-69

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