DP8891 Fiscal Policy and Learning

Author(s): George W. Evans, Seppo Honkapohja, Kaushik Mitra
Publication Date: March 2012
Keyword(s): Expectations, Government Spending, Permanent and temporary policy changes, Taxation
JEL(s): D84, E21, E43, E62
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8891

What is the impact of surprise and anticipated policy changes when agents form expectations using adaptive learning rather than rational expectations? We examine this issue using the standard stochastic real business cycle model with lump-sum taxes. Agents combine knowledge about future policy with econometric forecasts of future wages and interest rates. Both permanent and temporary policy changes are analyzed. Dynamics under learning can have large impact effects and a gradual hump-shaped response, and tend to be prominently characterized by oscillations not present under rational expectations. These fluctuations reflect periods of excessive optimism or pessimism, followed by subsequent corrections.