The market price of fiscal uncertainty

Recent fiscal interventions have raised concerns about US public debt, future distortionary tax pressure, and long-run growth potential. We explore the long-run implications of public financing policies aimed at short-run stabilization when: (i) agents are sensitive to model uncertainty, as in Hansen and Sargent (2007), and (ii) growth is endogenous, as in Romer (1990). We find that countercyclical deficit policies promoting short-run stabilization reduce the price of model uncertainty at the cost of significantly increasing the amount of long-run risk. Ultimately these tax policies depress innovation and long-run growth and may produce welfare losses.     

The “price puzzle” reconsidered

A large literature has employed structural vector autoregressive (SVAR) models to investigate the empirical effects of U.S. monetary policy. Many of these models regularly produce a “price puzzle”—a rise in the aggregate price level in response to a contractionary innovation to monetary policy—unless commodity prices are included. Conventional wisdom maintains that commodity prices resolve the price puzzle because they contain information that helps the Federal Reserve forecast inflation. I examine a number of plausible alternative indicator variables and find little correlation between an ability to forecast inflation and an ability to resolve the price puzzle. Additionally, a sub-sample investigation reveals that evidence of a price puzzle is associated primarily with the 1959-1979 sample period, and that most indicators—including commodity prices—cannot resolve the puzzle over this period.     

“Unfunded liabilities” and uncertain fiscal financing

A rational expectations framework is developed to study the consequences of alternative means to resolve the “unfunded liabilities” problem—unsustainable exponential growth in federal Social Security, Medicare, and Medicaid spending with no plan to finance it. Resolution requires specifying a probability distribution for how and when monetary and fiscal policies will change as the economy evolves through the 21st century. Beliefs based on that distribution determine the existence of and the nature of equilibrium. We consider policies that in expectation combine reaching a fiscal limit, some distorting taxation, modest inflation, and some reneging on the government's promised transfers. In the equilibrium, inflation-targeting monetary policy cannot successfully anchor expected inflation. Expectational effects are always present, but need not have a large impacts on inflation and interest rates in the short and medium runs.