Aggregate stability under a budget rule and labor mobility

Abstract

Whether a balanced budget rule stabilizes or destabilizes an economy depends on various factors such as the production function or the instrument used to balance the budget. This paper argues that migration, which has widely been neglected in the literature, also affects equilibrium properties. We study the effect of pro-cyclical labor mobility in a neoclassical growth model with public debt and a balanced budget requirement. Labor mobility can destabilize the economy due to external effects. After a negative shock hits the economy, living abroad becomes relatively more attractive, resulting in out-migration. This increases per capita public debt as migrants leave behind their implicit liabilities. The government increases tax rates to satisfy the balanced budget requirement, which further depresses the economy and increases out-migration. The destabilizing effect of public debt kicks in at only slightly higher debt levels than the ones observed in the Euro area after the financial crisis.