Abstract
The authors (CNS henceforth) consider an endogenous growth economy with exogenous government expenditures, a linear tax on labor income and a household that is afraid that the probability model of productivity and government expenditure shocks is misspecified. In particular, CNS use a stochastic version of an expanding input variety model à la Romer (1990) and explore the implications of two fiscal regimes: a balanced-budget regime and a fiscal regime that allows the accumulation of debt and involves primary deficits or surpluses when labor is below or above its steady-state value respectively.
CNS find that with full confidence in the model, the fiscal regime that allows for counter-cyclical deficits dominates in terms of welfare the balanced-budget regime. With doubts about the probability model though, the opposite happens. The explanation of this intriguing result is based on the formation of agents' expectations. Agents with concerns about misspecification use continuation utility in order to adjust pessimistically their expectations about the future. Counter-cyclical deficit policies, despite their welfare-enhancing potential in the short-run, posit long-run uncertainty in the sense of creating more persistent and volatile dynamics in continuation utility, towards which agents are averse. Agents adjust downwards their assessment of the present value of profits of a new input variety, innovate less and as a result, a lower growth rate in the economy is obtained.
In this comment, I will highlight some relevant ingredients of the CNS economy and make some points towards optimal fiscal policy.