The Effects of Fiscal Policy when Planning Horizons are Finite

How important is the planning horizon of households for the effects of fiscal plans? We address this question through the lens of a New-Keynesian model where households are boundedly rational and plan over a finite number of periods. We show that the planning horizon affects the medium-run cumulative multipliers significantly. Government spending cumulative multipliers increase with the horizon while labor tax cumulative multipliers drop, in absolute terms. In light of the recent debt crisis in the Euro Area, we look at spending cuts and labor income tax hikes. In line with the empirical literature, we find in our benchmark calibration that spending cuts are less recessionary than tax hikes. Looking at the interaction between the planning horizon and the persistence of the fiscal plans, we find that spending cuts become less recessionary while tax hikes more recessionary when the persistence of fiscal plans rise, and that this effect is amplified by shorter planning horizons. Introducing wage stickiness, we show that for very sticky wages, tax hikes become less recessionary than spending cuts, but that intermediate levels of wage stickiness have the opposite effect on fiscal multipliers when planning horizons are finite.

Keywords: Fiscal policy; Finite planning horizons; Bounded rationality
JEL codes E60; E62; E63; H63

Working paper no. 717