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Similarly, Krugman (2003), Niskanen (2006) and Bayoumi and Goncalves (2007) find that, in the United States, tax cuts do not tend to be followed by government spending restraint. Auerbach, Gale, and Orzag (2006) argue that paying for the tax cuts implemented by the Bush Administration via expenditure restraint alone would be politically difficult.
For recent examples of studies using this model class, see Farmer (2010) and Chadha and Nolan (2007).
As pointed out by Weil (1989), the critical feature of the Blanchard (1985) model is not the finite planning horizon of existing households per se, but rather the fact that after a household’s death new agents are born and inherit the liabilities of previous generations.
In general we allow for the possibility that agents may be more myopic than what would be suggested by a planning horizon based on a biological probability of death. This is similar to the new generation of models that combine infinitely lived and liquidity constrained agents, such as Gali, López-Salido and Vallés (2007), who suggest that one interpretation of liquidity constraints is extreme myopia.
Declining income profiles eliminate excessive sensitivity of human wealth to changes in the real interest rate. In models with exogenous labor supply and stationary population shares it can be shown that declining productivity profiles can be calibrated to produce identical macroeconomic behavior as more plausible hump-shaped life-cycle productivity profiles. See Faruqee and Laxton (2000).
A Technical Appendix (available upon request) provides a more comprehensive description of the model than is possible in the paper.
The turnover in the population is assumed to be large enough that the income receipts of the insurance companies exactly equal their payouts.
To facilitate simple closed-form solutions, both of these taxes as well as capital income taxes are assumed to be proportional.
Here Rk,t is the nominal rental rate of capital and qt is the shadow price of capital (Tobin’s q).
This assumption has become widely used. It addresses a key concern in open economy DSGE models, namely the potential for an excessive short-term responsiveness of international trade to real exchange rate movements.
The choice of γ is highly model specific and cannot be directly compared to calibrations of the intertemporal elasticity of substitution in infinite-horizon models.
Based on U.S. annual data starting in 1955 Bayoumi and Sgherri (2006) decisively reject the infinite horizon model and estimate a planning horizon that is significantly shorter than 10 years.
A fully satisfactory calibration of these parameters will require estimation. Given the wide application of this model to policy analysis inside the IMF this is an important part of our research agenda.
Note that the overall coefficient on inflation is therefore equal to 1.6.
As Calvo and Obstfeld (1988) emphasize, the social discount rate applied to future generations need not equal the pure time preference rate at which individuals discount their own future utilities.
See, for example, Ahearn (2004), who estimates that the three principal tax cuts implemented during 2001–03, namely, the Economic Growth and Tax Reform Reconciliation Act of 2001, the Job Creation and Worker Assistance Act of 2002, and the Jobs and Growth Tax Relief and Reconciliation Act of 2003, totaled two percent of net national product. Note that the results reported in this paper do not depend on the exact magnitude of the tax cut, as the same tax cut size is applied across all the simulations conducted.
Notice therefore that real interest rates are mostly driven by monetary policy over the first five years, and almost exclusively by fiscal policy thereafter.