Discussion Paper

No. 2010-14 | April 14, 2010
Fiscal Policy under Imperfect Competition: A Survey
(Submitted for Survey and Overview)

Abstract

This paper surveys the link between imperfect competition and the effects of fiscal policy on output, employment and welfare. We examine static and dynamic models, with and without entry under a variety of assumptions using a common analytical framework. We find that in general there is a robust relationship between the fiscal multiplier and welfare, the tantalizing possibility of Pareto improving fiscal policy is much more elusive. In general, the mechanisms are supply side, and so welfare improving policy, whilst possible, is not a general result.

Figures (68 KB,pdf)

JEL Classification

E62

Cite As

Luís F. Costa and Huw David Dixon (2010). Fiscal Policy under Imperfect Competition: A Survey. Economics Discussion Papers, No 2010-14, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2010-14

Assessment



Comments and Questions


Phillip Lawler - Invited Reader Comment
May 27, 2010 - 08:33

see attached file


Anonymous - Referee Report 1
May 31, 2010 - 08:31

see attached file


Huw Dixon - Response to referee 1.
July 07, 2010 - 16:14

Dear Referee 1, thanks for your comments. We would just like to respond to a couple of specific aspects.

(1) On the issue of nominal rigidity and fiscal policy. The issue of nominal rigidity and imperfect competition is indeed important: this is an issue which Dixon ...[more]

... has surveyed and discussed elsewhere, in (New Palgrave entry on New Keynesian Macroeconomics and Dixon 1998). However, whilst there is a current and growing literature on Fiscal policy in new neoclassical synthesis models, we felt that this is really a subject for a different survey (on page 2 point (6) we explicitly exclude this from our survey).

(2) From the historical perspective, there was an important and lasting contribution. Prior to these papers, in the standard neoclassical (and indeed new classical) macroeconomic models, the wealth effect on the labour supply had been suppressed: labour supply depended only on the real wage. Hence there was a vertical aggregate supply curve that was independent of the level of lump-sum taxation and government expenditure, and a (long-run) fiscal multiplier of zero. The Dixon-Mankiw-Startz papers introduced the link between expenditure, taxation and the labour supply that has since become a standard feature of fiscal policy analysis in NNS models. This is what you (referee 1) call the neoclassical supply side effect (indeed, Dixon called it Walrasian). However, I think you will find that this “neoclassical effect” is not present at all in the neoclassical literature prior to 1990. The first paper to explore it in the RBC setting was Baxter and King (1993). In many previous neoclassical models, the labour supply had been fixed (e.g Barro 1989) and in RBC models fiscal policy (Government expenditure and taxation) was usually omitted or treated as an exogenous shock process (e.g. Kydland and Prescott (1982), Prescott 1986)).

(3) However, the relationship of the literature surveyed to the current debates should be better highlighted. One which I think is important is that changes in imperfect competition over time (for example, due to globalisation) would lead one to expect changes in the effectiveness of fiscal policy.


Barro, (1989): The Neoclassical Approach to Fiscal Policy." In Modern Business Cycles, MIT Press, 1989
Baxter and King (1993): Fiscal Policy in General Equilibrium, American Economic Review vol. 83(3), pages 315-34.
Dixon (2007): "New Keynesian macroeconomics: Entry For New Palgrave Dictionary of Economics, 2nd Edition",
http://www.cardiff.ac.uk/carbs/econ/workingpapers/papers/E2007_3.pdf
Dixon (1998): The role of imperfect competition in new Keynesian economics, http://huwdixon.org/SurfingEconomics/chapter4.pdf
Kydland and Prescott (1982) Time to Build and Aggregate Fluctuations," Econometrica.
Prescott (1986), Theory ahead of measurement.


Anonymous - Referee Report 2
July 21, 2010 - 10:18

See attached file


Huw Dixon - Reply to referee 2.
November 09, 2010 - 16:44

Dear Referee 2, thanks for your comments.

1. We take your point this is not a comprehensive “survey”. We have chosen to rename the paper “an overview and survey”. We have added more references. I think in our defence we do refer to the earlier surveys (Silvestre and Dixon-Rankin) which ...[more]

... did cover a lot of the contributions you have identified.

2. On the endogeneity of the mark-up. Yes, we agree on the technical point that the mark-up is endogenous and determined by the elasticity of demand. However, I think that people understand what is meant by the shorthand “exogenous mark-up” as opposed to an endogenous mark-up (the latter being determined by something other than the CES parameter σ). We have altered our terminology somewhat to meet your point, replacing the word “exogenous” with “constant” to avoid confusion. We do still represent the comparative statics in terms of the markup rather than σ because this is clearer and indeed has become the convention.

3. In order to shorten the paper we also followed your suggestion and eliminated the unproductive-labour assumption.