Uncertain Duration of Reform: Dynamic Implications

We develop a framework to study the effects of policies of uncertain duration onconsumption dynamics under both complete and incomplete markets. We focus on the dynamicimplications of market incompleteness, specifically on the lack of state-contingent bonds. Twopolicies are considered: pure output-increasing and tariff-reducing (trade liberalization). Withcomplete markets, the output-increasing policy leads to flat consumption, while with nocontingent assets, consumption jumps upward on the announcement of the policy, continuesrising as long as the policy is in effect, and collapses when it is abandoned. A similarconsumption path obtains in a trade liberalization in the realistic case of low elasticity ofsubstitution and no rebate of tariffs. Market incompleteness rationalizes the existence ofgradual changes in consumption.