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Aggregate Stability and Balanced‐Budget Rules

Matteo Ghilardi () and Raffaele Rossi ()

Journal of Money, Credit and Banking, 2014, vol. 46, issue 8, 1787-1809

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.

Date: 2014
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Working Paper: Aggregate Stability and Balanced-Budget Rules (2014) Downloads
Working Paper: Aggregate Stability and Balanced-Budget Rules (2011) Downloads
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