Asset Prices, Business Cycles, and Markov-Perfect Fiscal Policy When Agents are Risk-Sensitive

Abstract

We study a business cycle model in which a benevolent scal authority must determine the optimal provision of government services, while lacking credibility, lump-sum taxes, and the ability to bond fi nance de ficits. Households and the fi scal authority have risk sensitive pref- erences. We find that outcomes are affected importantly by the household's risk sensitivity, but not by the fi scal authority's. Further, while household risk-sensitivity induces a strong precautionary saving motive, which raises capital and lowers the return on assets, its effects on fluctuations and the business cycle are generally small, although more pronounced for negative shocks. Holding the stochastic steady state constant, increases in household risk-sensitivity lower the risk-free rate and raise the return on equity, increasing the equity premium. Finally, although risk-sensitivity has little effect on the provision of government services, it does cause the fi scal authority to lower the income tax rate. An additional contribution of this paper is to present a method for computing Markov-perfect equilibria in models where private agents and the government are risk-sensitive decisionmakers.