Endogenous Business Cycles and Stabilization Policies

We analyze the effects of simple stylized economic policy rules, or stabilization principles, when fluctuations in economic activity are created endogenously by self_fulfilling volatile expectations. We study a simple monetary competitive model with intertemporally optimizing agents and a government. We only depart from neoclassical orthodoxy by assuming that a cycle or a sunspot equilibrium, not necessarily a steady state, could be the descriptive dynamic rational expectations equilibrium. The government may then well out of welfare concerns want to conduct systematic stabilization policy through transfers, expenditure, and taxation even though this has distortionary effects. We show that the policy rules that stabilize output in a way that is best for welfare involve countercyclical elements in government activity.