Alternative government financing and aggregate fluctuations driven by self-fulfilling expectations

Abstract

Using Woodford's finance-constrained model [Woodford, M., 1986. Stationary sunspot equilibria in a finance constrained economy. Journal of Economic Theory 40, 128–137] with external effects in production as in Barinci and Cheron [2001. Sunspots and business cycle in a finance constrained economy. Journal of Economic Theory 97, 30–49], this paper investigates the effects of alternative government financing methods on the range of values of increasing returns leading to an indeterminate steady state. It will be shown that indeterminacy may easily arise at a wide range of values of increasing returns if constant government expenditure is financed through labor income taxes, and with difficulty if constant government expenditure is financed by taxes on capital. In addition, we explore how the consequences of endogenous income taxes are changed if tax rates on labor and capital income are kept constant and government expenditure is endogenously adjusted to satisfy the budget constraint.