The welfare implications of resource allocation policies under uncertainty: The case of public education spending

In this paper, we examine whether policy interventions, aimed at improving resource allocation, also have important stabilization effects over the business cycle. To this end, we employ a dynamic stochastic general equilibrium model in which public education expenditures, financed by distorting taxes, enhance the productivity of private education choices. We then calculate the welfare implications of competing operating targets using a state-contingent instrument rule for public education spending. Our main findings are: (i) there can be important cyclical effects of different resource allocation policies depending on the operating target used and the degree of macroeconomic uncertainty; (ii) it is important to use an operating target which is as close as possible to the heart of the market imperfection that justifies policy action; (iii) policy action should not be monotonic in the degree of macroeconomic uncertainty.