The Simple Analytics of Assets' Values and Infrequent Policy Changes

Abstract

This paper studies the effects on financial markets of an anticipated fiscal stabilization policy in a stochastic environment. Stabilization is defined as a discrete change in the budget process which is implemented when government consumption reaches some threshold level, known by economic agents. Our analysis integrates the study of financial markets within the framework adopted by Bertola and Drazen (1993) to explain the effects of private consumption of an anticipated fiscal retrenchment, such as the fiscal reform implemented in Denmark in 1983. The actual behavior of Danish financial markets points in the direction of two interesting features of the policy change. First, in a model intertemporal consumption smoothing, one can replicate the observed boom in the stock market only with expectations of an increase in net income to stock-holders. The term-structure evidence on the other hand, is consistent with less than full credibility of the retrenchment, that is with investors attaching some probability to a further expansion of the government sector.