Aggregate Demand Management and Equilibrium Selection

We study optimal government policy in an economy where (i) search frictions create a coordination problem and generate multiple, Pareto-ranked equilibria and (ii) the government finances the provision of a public good by taxing trade. The government must choose the tax rate before it knows which equilibrium will obtain, and therefore an important part of the problem is determining how the policy will effect the equilibrium selection process. We examine two different models of equilibrium selection and show that they lead to the same conclusion: higher tax rates make coordination on the Pareto-superior outcome less likely. As a result, taking equilibrium selection effects into account leads to a lower optimal tax rate. We also show that public-employment policies that are inefficient from an equilibrium standpoint can be desirable when selection effects are considered. Journal of Economic Literature Classification Numbers: E61, D83. 1 PRELIMINARY DRAFT. Please do not cite without permission. We would like to thank seminar participants at Kentucky, Vanderbilt, the Federal Reserve Bank of Dallas, and the First Annual University of Texas ITAM workshop for helpful comments. The views expressed herein are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Richmond nor those of the Federal Reserve System.