Tuesday, May 14, 2013

Reduced form welfare

It is not uncommon to find theory papers that assume quadratic utility or loss functions. They are the most tractable functions that allow to find an optimum, yet there is no reason to believe they have anything to do with reality. If you are designing an optimal policy where trade-offs are important, the results hinges quite a bit on the functional forms you choose.

Jasper Lukkezen and Coen Teulings look at optimal fiscal policy and go a step further. They attach a VAR (vector autoregression) to a quadratic welfare function. Not only do they assume an analytically tractable but very likely unrealistic welfare function, they also assume the rest of the economy is entirely linear with relationships that are policy invariant (it is a VAR). For their application, welfare is determined over GDP and the unemployment rate, which may be fine to determine the loss function of a policy maker but has nothing to do with the well-being of economic agents. They care about risk, uncertainty, consumption and time off work, all of which are absent from the model. Hence I do not really understand what the results mean, especially as the optimal policy rules are all over the place. A very confusing paper.

No comments: