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The consequences of an unknown debt target

Alexander Richter () and Nathaniel Throckmorton

European Economic Review, 2015, vol. 78, issue C, 76-96

Abstract: Several proposals to reduce U.S. debt reveal large differences in their targets. We examine how an unknown debt target affects economic activity using a real business cycle model in which Bayesian households learn about a state-dependent debt target in an endogenous tax rule. Recent papers use stochastic volatility shocks to study fiscal uncertainty. In our setup, the fiscal rule is time-varying due to unknown changes in the debt target. Households infer the current debt target from a noisy tax rule and jointly estimate the transition probabilities. Three key findings emerge from our analysis: (1) limited information about the debt target amplifies the effect of tax shocks through changes in expected tax rates; (2) the welfare losses are an order of magnitude larger when both the debt target state and transition matrix are unknown than when only the debt target state is unknown to households; (3) an unknown debt target likely reduced the stimulative effect of the ARRA and uncertainty about the sunset provision in the Bush tax cuts may have slowed the recovery and led to welfare losses.

Keywords: Bayesian learning; Limited information; Fiscal policy; Welfare; Anticipated utility (search for similar items in EconPapers)
JEL-codes: D83 E32 E62 H68 (search for similar items in EconPapers)
Date: 2015
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Working Paper: The Consequences of Uncertain Debt Targets (2013) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:eee:eecrev:v:78:y:2015:i:c:p:76-96

DOI: 10.1016/j.euroecorev.2015.05.002

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