Working Paper

Individual and Aggregate Constrained Efficient Intertemporal Wedges in Dynamic Mirrleesian Economies

Abstract: Assuming a neoclassical production technology, this paper characterizes constrained efficient intertemporal wedges for the macro aggregate as well as the micro individual allocation of dynamic Mirrleesian economies. We first construct ?Pareto-Negishi weights? from the multipliers on a sequence of temporary incentive constraints. For a fairly general stochastic process of idiosyncratic productivity shocks, we show that the evolution of the Pareto-Negishi weight associated with agents? consumption is a nonnegative martingale. This powerful property enables us to deliver three contributions to the literature. First, we demonstrate that several celebrated constrained efficient intertemporal results of the individual allocation in the literature can be all attributed to originating from the nonnegative martingale property of consumption Pareto-Negishi weights. Second, we address optimal distortion for the aggregate allocation and establish that the constrained efficient intertemporal wedge for aggregate saving will be negative or positive, depending on whether the intertemporal elasticity of substitution is elastic or inelastic. This result is another application of the nonnegative martingale property. Third, we show how the nonnegative martingale property is modified in the presence of additional frictions and shed new light on incorporating different types of constraints documented in the literature.

Keywords: Intertemporal wedges; Nonnegative martingale; Inverse Euler equation; Immiseration;

JEL Classification: D82; E21; H21;

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Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2016-04-01

Number: 2015-43

Pages: 47 pages