The general equilibrium effects of fiscal policy

the consumption-leisure intratemporal trade-off. The nominal flow budget constraintfor Ricardian agent i is given by[](1−τ w t )w t (i)l R t (i) + (1−τ k t ) Rt k k R t (i)u t (i) + D R t(i) + B R t(i) + Tr R t(i) + τ c tP1+τ c t I R t (i) =t=P t c R t (i) + P t I R t (i) + BR t+1(i)+ P t ψ(u t (i))k R t (i) + φ ( ) 2 wt (i)R t 2 w t−1 (i) − π W t (5)where (1 − τ w t )w t l R t is net labor income, (1 − τ k t )Rt k k R t u t is net nominal income fromrenting capital services k R t = k R t u t (where the bar indicates physical units of capital,while u t is utilization intensity) to firms at the rate Rt k , D R t are dividends distributedby firms to Ricardians (by assumption, the only firms’ owners). The fiscal authoritymakes net lump-sum transfers Tr t and finances its expenditures by issuing one periodmaturity discount nominal bonds B t and by levying taxes on labor income (τ w t ), capitalincome (τ k t ) and consumption (τ c t). Consumption tax introduces a wedge between theproducer price index ˜P t and the consumers one P t = (1 + τ c t) ˜P t . We assume that noindirect taxes are paid on purchases of investment goods, so that the price index ofinvestment goods is the wholesale price ˜P t . Instead of having two price levels in theconsumers’ problem, we include among the uses (r.h.s. of the budget constraint) theinvestment expenditure expressed in prices gross of taxes P t I R t and compensate it witha rebate equal toτ c tP1+τ c t I R t , so that the difference between the two is equal to the actualtexpenditure on investment goods ˜P t I R t . Uses also feature the amount of governmentbonds that Ricardian households carry over to the following period, discounted by thenominal interest rate R t = 1 + i t . Finally, adjustment costs are introduced on thehouseholds choices of the nominal wage w t and of capacity utilization u t . The first isincurred if the nominal wage deviates from the steady state path (on which gross wageinflation π W is assumed equal to gross price inflation π) and is expressed in terms of theequilibrium wage rate W t (see Kim, 2000). The second is incurred if the level of capitalutilization changes with respect to its steady state value of 1; this cost is described byan increasing convex function ψ(u t ), with ψ(1) = 0. Hence ψ(u t )k R t denotes the cost(in terms of consumption units) associated with the utilization level u t .The physical capital accumulation law is[ ( )]k R t+1(i) = (1 − δ) k R εit (i) + 1 − s t I R t (i)I RI R t (i) (6)t−1(i)( )ε iwhere not all new investment gets transformed into capital and the term s t I R tI R I R tt−1describes (in terms of capital loss) the cost of adjustment the agent incurs if he varies11