sets being subject to normal decision making and as a result economic agents
can save either too little or too much as compared to the full information case.
The approach of counter cyclical deficits is the most natural instrument that can
influence the level of savings and physical capital formation. The government
can eliminate cycles and increase welfare by running a deficit when economic
agents are overly pessimistic and maintaining a surplus when economic agents
undersave. In general, a bond issue, or purchases of physical capital, in the
amount of
bt = ∆kt = kt - kFF (39)
restores the full information equilibrium. Again this assumes that the govern-
ment is fully aware of the price value of kFF, which is seldom the case in practice
and, thus makes the policy ineffective. Nevertheless, any form of an automatic
stabilizer, such as a proportional tax, can limit the scope of inefficiencies re-
sulting from expectations revisions. Similarly, measures that boost consumer
confidence during recessions can be welfare improving as these increase the level
of consumer spending and bring the economy to the full information level of out-
put.
Output growth that exceeds the speed of expansion of the productive ca-
pacity of the economy eventually leads to an adjustment in the price level.
Therefore, movements of the price level can serve as signals for policy decisions.
Specifically, policy makers routinely choose to follow restrictive policies when
price increases. Naturally, such a policy helps to bring the level of output to
its potential, however, it remains orthogonal to economic theory as departures
of output above or below its potential are not supported by the assumption of
rational decision making. The model developed in this paper not only shows
that counter cyclical policy indeed helps to restore the potential level of output,
but it also confirms viability of the policy. The model exhibits standard demand
side disturbances properties. In particular, it captures a positive correlation be-
tween price and demand increases. Specifically, several steps of algebra allow to
establish
(Pt - p)(ÿt - ÿ) ~ (β - βt)2 , (40)
where variables with an upper bar denote the variables that would materialize
under perfect foresight. Clearly, a price that exceeds p is indicative of output
exceeding the potential and calls for a restrictive policy action as not fully
informed agents overspend. On the other hand a price that is below p signals a
slump in demand and justifies an expansionary mode as economic agents hold
too pessimistic expectations. Therefore, policy makers can observe movements
in the price level and base their decisions on price level changes. The model
is, thus, consistent with practice normally observed in reality as it justifies a
restrictive policy move in the case of inflation.
Blanchard [4] argued that the 1990/91 recession was an outcome of a con-
sumption shock. The shock itself is left unexplained. However, a revision of
overly optimistic consumption plans is listed as a potential cause of the shock.
Naturally, the argument allows implicitly for the possibility of economic agents
being unable or choosing not to follow optimal consumption plans. Similarly,
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