Tuesday 11
Session Leonor Modesto - Macroeconomic Dynamics
Leonor Modesto
› 10:00 - 10:30 (30min)
› 403
The failure of stabilization policy: fiscal rules in the presence of incompressible public expenditures
Leonor Modesto  1, 2@  , Nicolas Abad  1, 2@  , Teresa Lloyd-Braga  1, 2@  
1 : UCP, Catolica Lisbon School of Business and Economics  (UCP-CLSBE)  -  Website
Palma de Cima, 1649-023, Lisboa -  Portugal
2 : CUBE - Católica Lisbon School of Business and Economics  (CUBE)

We consider a Ramsey model with possible increasing returns to scale and a government. The government balances its budget at each point in time and issues (i) a tax on income in order to finance unavoidable public expenditures, and (ii) further uses a tax rate rule with the purpose of stabilizing the economy. We show that insulating this economy from belief driven fluctuations is not possible if the government needs to raise a fixed amount of tax revenues to finance incompressible public expenditures. In this case, we always have steady state multiplicity (exactly two steady states) and global indeterminacy, while local indeterminacy is also possible. More precisely, even if a sufficiently procyclical tax rate is still able to eliminate local indeterminacy, two saddle steady states prevail, so that, depending on expectations, the economy may either converge to the low steady state or to the high steady state. This implies that a regime switching rational expectation equilibrium, where the economy switches between paths converging to the two different steady states, easily arises. As expectations are able to influence long run outcomes, our model is able to generate large and sudden boom and boost cycles in response to expectation shocks. Therefore, incompressible public expenditures may also be responsible for the sharp and sudden recession observed in the last decade.

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