Budget Rules and Macroeconomic Stability with Endogenous Growth

Abstract

In this paper we study the basic endogenous growth model with externalities of capital and elastic labour supply and analyze how budget rules affect stability of the economy. The government levies an income tax with a constant rate and finances public expenditures which are neither productive nor welfare enhancing. Two budget rules are analyzed. The first is the inter-temporal budget constraint of the government, the second is the balanced budget rule. The paper demonstrates that the balanced growth path in the economy with a balanced budget is unique and saddle point stable. The economy with public deficits yields a unique balanced growth path which is either saddle point stable or unstable. Further, the balanced budget rule yields a higher long-run growth rate.