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Aggregate Stability and Balanced‐Budget Rules
Author(s) -
GHILARDI MATTEO F.,
ROSSI RAFFAELE
Publication year - 2014
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/jmcb.12166
Subject(s) - constant elasticity of substitution , economics , business cycle , elasticity of substitution , econometrics , mathematical economics , balanced budget , production (economics) , indeterminacy (philosophy) , monotonic function , aggregate (composite) , function (biology) , microeconomics , mathematics , macroeconomics , mathematical analysis , physics , materials science , quantum mechanics , evolutionary biology , politics , biology , political science , law , composite material
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.