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Balanced-Budget Rules, Elasticity of Substitution, and Macroeconomic (In)Stability

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  • JIANPO XUE
  • CHONG K. YIP

Abstract

This paper examines the relation between factor substitution and (local) stability of equilibria in a one-sector real business cycle model under balanced-budget rules. We show that under non-unitary elasticity of factor substitution, the Schmitt-Grohé-Uribe indeterminacy result can be altered. Using the two-step normalization procedure, we highlight two opposing effects of factor substitution, namely, the efficiency effect and the distribution effect, on aggregate stability. With endogenous distortionary taxes and gross substitutability between capital and labor, the existing literature overlooks the distribution effect and finds that balanced-budget rules are likely to deliver indeterminacy. However, if capital stock is relatively more abundant, a higher elasticity of substitution generates a source of stability due to the distribution effect. Our calibration shows that the distribution effect is always the dominating force.

Suggested Citation

  • Jianpo Xue & Chong K. Yip, 2015. "Balanced-Budget Rules, Elasticity of Substitution, and Macroeconomic (In)Stability," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 17(2), pages 196-218, April.
    • Handle: RePEc:bla:jpbect:v:17:y:2015:i:2:p:196-218
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    3. Bom, Pedro R.D., 2019. "Fiscal rules and the intergenerational welfare effects of public investment," Economic Modelling, Elsevier, vol. 81(C), pages 455-470.
    4. David R. Stockman, 2022. "Balanced‐budget rules: Local indeterminacy and bifurcations," International Journal of Economic Theory, The International Society for Economic Theory, vol. 18(2), pages 109-136, June.
    5. Huang, Kevin X.D. & Meng, Qinglai & Xue, Jianpo, 2017. "Balanced-budget income taxes and aggregate stability in a small open economy," Journal of International Economics, Elsevier, vol. 105(C), pages 90-101.
    6. Kevin X.D. Huang & Qinglai Meng & Jianpo Xue, 2018. "Balanced‐Budget Rules and Aggregate Instability: The Role of Endogenous Capital Utilization," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 50(8), pages 1669-1709, December.
    7. Fujisaki, Seiya, 2016. "Aggregate Stability in Monetary Economy with Consumption Tax and Taylor Rule," MPRA Paper 69833, University Library of Munich, Germany.

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