AGGREGATE MODEL OF FISCAL/MONETARY POLICY

Aggregate Model of Fiscal/Monetary policy



Aggregate Model for Fiscal/Monetary Policy

Introduction

Most of the macroeconomic literature relies on the representative agent paradigm. The assumption of a representative agent is generally made for technical simplicity, since the solution of dynamic models with heterogeneous agents is computationally challenging. However, the study of aggregate data might provide the incorrect evaluation of economic theories. For example, the researchers known as Attanasio and Weber (1993) demonstrate that the use of microeconomic data can overturn rejections of consumer intertemporal optimization models based on aggregate data. In addition, the assumption comes at the cost of preventing the analysis of important questions such as whether economic policies equally affect individuals with different characteristics, whether they influence inequality, or what are the macroeconomic consequences of aggregate fluctuations on the welfare of individuals that differ in their consumption patterns. In other words, while the representative agent assumption allows macroeconomists to study how average values of macroeconomic variables are affected by economic policies, it does not allow them to study how these policies affect the distribution of such variables across households. Therefore, all the issues and aspects related to the aggregate model for Fiscal and Monetary Policy will be discussed in detail.

Importance of Fiscal Policy

Fiscal policy analysis is an especially important area of macroeconomics since it has direct implications for consumers' welfare. The literature has extensively studied the effects of government spending and tax policy shocks on aggregate macroeconomic variables. A distinct aspect of any economic model lies in its detailed fiscal policy setup. Above all, this model makes the explicit assumption that a certain portion of government spending is productive. Since government spending is the sum of government consumption and investment, the assumption can be modeled by separately considering productive government investment and unproductive government consumption. By expanding productive public capital in the future, a fiscal shock to government investment entails macroeconomic consequences different from a government consumption shock. As a consequence, the quantitative importance of the fiscal financing source hinges substantially on the nature of the government spending shock (Frontline, 2010).

The influence of Fiscal Policy on the Economy

Solid lines represent the outcomes when only lump sum transfers adjust, whereas dotted-dashed lines represent outcomes when only income taxes adjust. The results show that an unproductive government spending shock supports the “neoclassical view” transmitted by a negative wealth effect, regardless of the source of fiscal financing. Households feel poorer due to future higher taxes or lower transfers, both of which raise labor and decrease consumption at impact. Accordingly, output rises at the impact period. However, the dynamic responses of the variables vary across the sources of future debt financing. In addition to a negative wealth effect, income tax financing creates distortionary margins that rapidly exacerbate the initial stimulus effects. Anticipated capital tax rate hikes suppress households' incentive to save during the current period, causing marginal productivity of labor, thus households' labor supply, to fall immediately. Decline in the labor supply is accelerated as higher labor tax ...