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COMPUTING MARKOV-PERFECT OPTIMAL POLICIES IN BUSINESS-CYCLE MODELS

Published online by Cambridge University Press:  28 September 2015

Richard Dennis  and
Tatiana Kirsanova
Richard Dennis*
Affiliation:
University of Glasgow
Tatiana Kirsanova
Affiliation:
University of Glasgow
*
Address correspondence to: Richard Dennis, Adam Smith Business School, University of Glasgow, Main Building, University Avenue, Glasgow G12 8QQ, United Kingdom; e-mail: richard.dennis@glasgow.ac.uk.
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Abstract

Time inconsistency is an essential feature of many policy problems. This paper presents and compares three methods for computing Markov-perfect optimal policies in stochastic nonlinear business cycle models. The methods considered include value function iteration, generalized Euler equations, and parameterized shadow prices. In the context of a business cycle model in which a fiscal authority chooses government spending and income taxation optimally, although lacking the ability to commit, we show that the solutions obtained using value function iteration and generalized Euler equations are somewhat more accurate than that obtained using parameterized shadow prices. Among these three methods, we show that value function iteration can be applied easily, even to environments that include a risk-sensitive fiscal authority and/or inequality constraints on government spending. We show that the risk-sensitive fiscal authority lowers government spending and income taxation, reducing the disincentive to accumulate wealth that households face.

Keywords

Markov-Perfect PolicyTime ConsistencyFiscal Policy
Type
Articles
Information
Macroeconomic Dynamics , Volume 20 , Issue 7 , October 2016 , pp. 1850 - 1872
Copyright
Copyright © Cambridge University Press 2015 

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