Fiscal Policy and Asset Prices with Incomplete Markets

We study the simultaneous impact of fiscal policy decisions on macroeconomic activity, wealth distribution, and asset prices. We consider a general equilibrium, overlapping generations model with incomplete markets and heterogeneous agents, where government debt and capital are imperfect substitutes. Increases in public debt lead to significant increases in the riskless rate and to a reduction in the equity premium, while higher capital income tax rates lead to a higher equity premium. The crowding-out effects (on capital and output) are much higher than in models where government debt and capital are perfect substitutes, which thus ignore households' portfolio reallocation decisions. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.