Home > Research > Publications & Outputs > Aggregate stability and balanced-budget rules

Associated organisational unit

View graph of relations

Aggregate stability and balanced-budget rules

Research output: Contribution to Journal/MagazineJournal articlepeer-review

<mark>Journal publication date</mark>12/2014
<mark>Journal</mark>Journal of Money, Credit and Banking
Issue number8
Number of pages23
Pages (from-to)1787-1809
Publication StatusPublished
<mark>Original language</mark>English


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.