Optimal Monetary and Fiscal Policy under Limited Foresight

August 2026

Optimal Monetary and Fiscal Policy under Limited Foresight

Martin Bodenstein and Junzhu Zhao

Abstract:

We investigate Barro's random walk hypothesis according to which distortionary labor taxes should follow a random walk for any stochastic process of government expenditures, see Barro (1979). When agents experience cognitive discounting as in Gabaix (2020), they perceive government debt as wealth, and the random walk result breaks down except for knife-edge combinations of limited rationality by policymakers and the private sector. For these specific parameter values, the result can reemerge, but minor deviations from these knife-edge combinations lead to stationary equilibrium dynamics, reflecting the wealth effect of government debt. However, the dynamics turn explosive when policymakers discount the future excessively. Our results extend to other models with limited foresight such as Blanchard (1985), Weil (1989), or Woodford (2019).

Keywords: monetary policy, fiscal policy, limited foresight

DOI: https://doi.org/10.17016/IFDP.2026.1444

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