Aggregate Stability and Balanced-Budget Rules

Abstract

It has been shown that under perfect competition and a Cobb-Douglas production function, a basic real business cycle model may exhibit indeterminacy and sunspot fluctuations when income tax rates are determined by a balanced-budget rule (BBR). This paper introduces in an otherwise standard real business cycle model a more general and data-coherent class of production functions, namely, a constant elasticity of substitution production function. We show that the degree of substitutability between production factors is a key ingredient to understanding the (de)stabilizing properties of a BBR. Then we calibrate the model consistently with the empirical evidence; that is, we set the elasticity of substitution between labor and capital below unity. We show that compared to the Cobb-Douglas case, the likelihood of indeterminacy under a BBR is greatly reduced in the U.S., the EU, and the UK.

Cite this work

No public copy is stored for this record, so only the metadata is cited.

Stored only when both papers are in the corpus — 21 citations exist upstream.

Papers that cite the same references — the relational fallback while embeddings are still backfilling.