Aggregate Stability and Balanced-Budget Rules

Matteo Francesco Ghilardi () and Raffaele Rossi ()

No 411, School of Economics Discussion Papers from School of Economics, University of Surrey

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 sunspots fluctuations when income tax rates are determined by a balanced-budget rule. 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 understand the (de)stabilising properties of a balanced-budget rule. Furthermore, when we calibrate the model consistently with the empirical evidence, i.e. the elasticity of substitutions between labour and capital below unity, balanced-budget rules deliver determinacy for a broad range of OECD countries.

Keywords: Constant Elasticity of Substitution; Balanced-Budget Rules; Indeterminacy; Business Cycles (search for similar items in EconPapers)
JEL-codes: E32 E62 (search for similar items in EconPapers)
Date: 2011-05
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Persistent link: http://EconPapers.repec.org/RePEc:sur:surrec:0411

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