The Consequences of an Unknown Debt Target

32 Pages Posted: 20 Feb 2013 Last revised: 29 Jun 2015

Alexander W. Richter

Federal Reserve Bank of Dallas

Nathaniel A. Throckmorton

College of William and Mary

Date Written: January 18, 2015

Abstract

Several proposals to reduce U.S. debt reveal large differences in their targets. We examine how an unknown debt target affects economic activity using a real business cycle model in which Bayesian households learn about a state-dependent debt target in an endogenous tax rule. Recent papers use stochastic volatility shocks to study fiscal uncertainty. In our setup, the fiscal rule is time-varying due to unknown changes in the debt target. Households infer the current debt target from a noisy tax rule and jointly estimate the transition probabilities. Three key findings emerge from our analysis: (1) Limited information about the debt target amplifies the effect of tax shocks through changes in expected tax rates; (2) The welfare losses are an order of magnitude larger when both the debt target state and transition matrix are unknown than when only the debt target state is unknown to households; (3) An unknown debt target likely reduced the stimulative effect of the ARRA and uncertainty about the sunset provision in the Bush tax cuts may have slowed the recovery and led to welfare losses.

Keywords: Bayesian Learning, Limited Information, Fiscal policy, Welfare, Anticipated Utility

JEL Classification: D83, E32, E62, H68

Suggested Citation

Richter, Alexander W. and Throckmorton, Nathaniel A., The Consequences of an Unknown Debt Target (January 18, 2015). European Economic Review, Vol. 78, 2015. Available at SSRN: https://ssrn.com/abstract=2220247 or http://dx.doi.org/10.2139/ssrn.2220247

Alexander W. Richter (Contact Author)

Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5360 (Phone)

HOME PAGE: http://alexrichterecon.com

Nathaniel A. Throckmorton

College of William and Mary ( email )

P.O. Box 8795
Williamsburg, VA 23187
United States

HOME PAGE: http://nathrockmorton.people.wm.edu/

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