Credibility Flashcards
State the original command economy utility function
N [2c + (1-l )+ 4g]
State each households’ market economy utility function
2 c + ( 1-l ) + utility from public good
subject to: c = (1–τ) w l
What is the point of the Ramsay problem?
Optimizing taxation in a market economy
State the economy utility function for optimal taxation (Ramsay problem)
max N [2c + (1-l )+ 4g]
subject to: N * g = τ * N * w * l
and: w= 1
What is g, if tax ≤ 0.5 in a market economy ?
if tax ≤ 0.5 then l=1, c=1–τ
Since N [2c + (1-l )+ 4g]
g = tax
What is g, if tax > 0.5 in a market economy ?
if tax > 0.5 then l=0, c=0
Since N [2c + (1-l )+ 4g]
g = 0,5
How does rational expectations affect optimal taxation (Ramsay problem)?
Since the labor force considers what they expect, rather than what the government promises, the government’s promises are worthless. Therefore, the labor force moves first, and the short-run nash equilibrium is to defect and provide l=0.
(allocation allocation l = c = g = 0)
If they only listened to the government, the government could set taxes higher than they promised, which would be better for everyone.
Which are the three “Cures for temptation” (to exploit the short-run supply curve)
- Repetition
- Appoint an ignorant central banker
- Appoint a heartless central banker
How can a household maximize its utility if taxation is ≤ 0.5 in a market economy?
l = 1 which gives c = 1 - τ
How can a household maximize its utility if taxation is > 0.5 in a market economy?
l = 0 which gives c = l = 0
What is the optimal solution to the Ramsey problem (for the population in total)?
τ =0.5 which gives l = 1 and c = 0.5 and g =0.5
…leading to a total of 3 utils
When can it be good to “deviate” in a repeated Ramsey problem, i.e. promise tax 0.5 and then set 1?
When the discount factor is such that the present value of future payoffs (high in year zero, low all following years) is higher than those of not deviating.
Why is it good to have a “heartless” central banker?
If he/she doesn’t care about employment at all, he/she won’t exploit the Phillip’s curve since it raises inflation
Why is it good to have a “heartless” central banker?
If he/she doesn’t care about employment at all, he/she won’t exploit the Phillip’s curve since it raises inflation
Why is it good to have an “ignorant” central banker?
If he/she doesn’t know about the Phillip’s curve he/she won’t be tempted to exploit it
