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Schmitt-Grohe and Uribe (1997) demonstrate that a balanced-budget fiscal policy can induce aggregate instability unrelated to economic fundamentals. The empirical relevance of this result has been challenged by subsequent studies. In this paper we show, both analytically and numerically, that such extrinsic instability is an empirically robust plausibility associated with a balanced-budget rule once endogenous capital utilization is taken into consideration. This suggests that the design or operation of a balanced-budget fiscal policy must recognize that it may constitute a practical source of self-fulfilling prophecies and belief-driven fluctuations.

This paper examines the instability property of balanced-budget taxation on factor income and consumption in a two-sector real business cycle model with home production. We show that the presence of home production, which is a nontaxed sector, reinforces the intratemporal and intertemporal substitution effects of balanced-budget rules. As a result, it strengthens the destabilization effect of factor income taxes and weakens the stabilization effect of consumption taxes. Moreover, our calibration shows that the number of OECD countries’ tax-rate combinations that fall into the instability region rises when home goods account for a larger share of aggregate consumption, and hence persistent cycles can easily occur following a fundamental shock or a sunspot shock.

In a closed economy setting a cash-in-advance monetary economy under money growth targeting is prone to self-fulfilling expectations and beliefs-driven fluctuations. This paper shows that such extrinsic instability is less of a problem in a small open economy integrated in the world goods and financial markets. This is because endogenous terms-of-trade movements associated with global goods trade and cross-border capital flows and endogenous international asset price adjustments associated with global financial transaction serve as an endogenous stabilizer to reduce the likelihood of sunspot equilibria. We find that for empirically reasonable parametrization of the small open economy sunspot beliefs are unlikely to become self-fulfilled.

In a real macroeconomic model, it is well established that a balanced-budget rule based on consumption tax can rule out indeterminacy. The present paper shows, both analytically and numerically, that such a balanced-budget rule induces indeterminacy and, hence, aggregate instability in a standard one-sector cash-in-advance economy. From a policy perspective, our results raise possible concerns that balanced-budget rules with endogenous consumption tax could have destabilizing effects under the current over-easy monetary environment.

In this paper, we examine the effects of constant-rate factor taxation on macroeconomic stability in the Woodford (1986) model. Our focus is on how the degree of factor substitution, as measured by the elasticity of factor substitution (EOS) in production, affects different balanced-budget tax rules. Analytically, we show that indeterminacy can occur under capital income taxation only when the EOS is very low, whereas indeterminacy under labor income taxation is not subject to the EOS restriction. This finding is robust when we tax all of the factor incomes with equal rates. Thus, in terms of macroeconomic stability, taxing capital income is preferred to taxing labor income.

We show that, with endogenous investment, virtually all monetary policy rules that set a nominal interest rate in response solely to expected future inflation induce real indeterminacy in models with (i) staggered prices, (ii) staggered prices and staggered wages, and (iii) staggered prices, staggered wages, and firm-specific capital. In (i), policy's response to current output can help significantly in ensuring determinacy with an infinite labor supply elasticity, but little with empirically plausible labor supply elasticity. In (ii), responding to output always helps a great deal, though under low price stickiness and without capital adjustment cost it may call for a moderate response to output in order to ensure determinacy for a wide range of response to inflation. In (iii), even a tiny response to output can always render equilibrium determinate for a wide range of response to inflation.