Uncertain Duration of Reform: Dynamic Implications
Calvo, Guillermo A.
Calvo, Guillermo A. and Allan Drazen, "Uncertain Duration of Reform: Dynamic Implications," Macroeconomic Dynamics, Volume 2, Issue 4, December 1998, pp 443-455.
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We develop a framework to study the effects of policies of uncertain duration on consumption dynamics under both complete and incomplete markets. We focus on the dynamic implications of market incompleteness, specifically on the lack of state-contingent bonds. Two policies are considered: pure output-increasing and tariff-reducing (trade liberalization). With complete markets, the output-increasing policy leads to flat consumption, while with no contingent assets, consumption jumps upward on the announcement of the policy, continues rising as long as the policy is in effect, and collapses when it is abandoned. A similar consumption path obtains in a trade liberalization in the realistic case of low elasticity of substitution and no rebate of tariffs. Market incompleteness rationalizes the existence of gradual changes in consumption.