Abstract
Productivity externalities create room for Keynesian-type stabilization to insulate the economy from belief-driven fluctuations. Conventional wisdomindicates that in a Benhabib-Farmer-Guo one-sector model, a progressive tax schedule operates like an automatic stabilizer that mitigates business cycle fluctuations, but in an indeterminate two-sector real business cycle model a regressive, rather than a progressive, tax policy stabilizes the economy against sunspot-driven fluctuations. This paper proposes an alternative policy - an income tax-cum-consumption tax schedule-to stabilize the economy against sunspot fluctuations. We show numerically that the government can suppress belief-driven fluctuations by implementing a tax switch decreasing the income tax and increasing the consumption tax. This result is robust not only in a two-sector model with sector-specific externalities, but also in a one-sector model with aggregate productivity externalities.
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