Review of Economic Dynamics 10 (2007) 31–54
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Time-consistent fiscal policy and
heterogeneous agents
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Roc Armenter
International Research Department, Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045
Received 17 February 2006; revised 7 August 2006
Available online 12 September 2006
Abstract
This paper characterizes the time-consistency properties of the set of Pareto efficient (or second best)
fiscal policies, in a two-class, stochastic economy similar to that in [Judd, K.L., 1985, Redistributive taxation
in a simple perfect foresight model, Journal of Public Economics 28, 59–83]. The key finding is that the
continuation of any Pareto efficient policy is always Pareto efficient. Hence, to require any policy revision
to be approved by unanimity safeguards the time consistency of efficient fiscal policy. I also show that any
Pareto efficient policy from a timeless perspective can be rendered time consistent by a policymaker whose
objective function is given by a utilitarian social welfare function with precise welfare weights. These results
link the policymaker’s equity considerations with the credibility of efficient fiscal policy.
©
2006 Elsevier Inc. All rights reserved.
JEL classification: E61; E62
Keywords: Fiscal policy; Time-consistency; Equity considerations
1. Introduction
In the representative agent model, the optimal fiscal policy is usually not time-consistent.
Hence its implementation in a rational expectations equilibrium requires a commitment technol-
ogy, as pointed out in Kydland and Prescott (1977) and Fischer (1980). However, fiscal policy is
rarely coded in constitutions—an obvious commitment device. There is a large literature explor-
ing alternative mechanisms that render the optimal fiscal policy time-consistent. In the absence of
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The views expressed here are those of the author and do not necessarily reflect the position of the Federal Reserve
Bank of New York or the Federal Reserve System.
E-mail address: roc.armenter@ny.frb.org.
1094-2025/$ – see front matter © 2006 Elsevier Inc. All rights reserved.
doi:10.1016/j.red.2006.08.003