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Fiscal consolidations and finite planning horizons

Joep Lustenhouwer and Kostas(Konstantinos) Mavromatis ()

No 130, BERG Working Paper Series from Bamberg University, Bamberg Economic Research Group

Abstract: We analyze fiscal consolidations using a New-Keynesian model where agents have finite planning horizons and are uncertain about the future state of the economy. Both consumers and firms are infinitely lived, but only plan and form expectations up to a finite number of periods into the future. The length of agents' planning horizons plays an important role in determining how spending cuts or tax increases affect output and inflation. We find that for low degrees of relative risk aversion spending-based consolidations are less costly in terms of output losses, in line with empirical evidence. A stronger response of monetary policy to inflation makes spending-based consolidations more favorable as well. Interestingly, for short planning horizons, our model captures the positive comovement between private consumption and government spending observed in the data.

Keywords: Fiscal policy; Finite planning horizons; Bounded rationality (search for similar items in EconPapers)
JEL-codes: E60 E62 E63 H63 (search for similar items in EconPapers)
Date: 2017
New Economics Papers: this item is included in nep-dge, nep-mac, nep-pbe and nep-upt
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