Useful Government Spending and Macroeconomic (In)stability under Balanced-Budget Rules

Sharon Harrison and Jang-Ting Guo

No 701, Working Papers from Barnard College, Department of Economics

Abstract: It has been shown that an otherwise standard one-sector real business cycle model may exhibit indeterminacy and sunspots under a balanced-budget rule that consists of fixed and “wasteful” government spending and proportional income taxation. However, the economy always displays saddle-path stability and equilibrium uniqueness if the government finances endogenous public expenditures with a constant income tax rate. In this paper, we allow for productive or utility-generating government purchases in either of these specifications. It turns out that the previous indeterminacy results remain unchanged by the inclusion of useful government spending. By contrast, the earlier determinacy results are overturned when public expenditures generate sufficiently strong production or consumption externalities. Our analysis thus illustrates that a balanced-budget policy recommendation which limits the government’s ability to change tax rates does not necessarily stabilize the economy against belief-driven business cycle fluctuations.

Keywords: Public Expenditures; Balanced-Budget Rules; Indeterminacy; Business Cycles. (search for similar items in EconPapers)
JEL-codes: E32 E62 (search for similar items in EconPapers)
Pages: 17 pages
Date: 2006-07
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Journal Article: Useful Government Spending and Macroeconomic (In)stability under Balanced‐Budget Rules (2008)
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