Expectations-driven Fluctuations Research Articles

Lack of Commitment, Retroactive Taxation, and Macroeconomic Instability

Abstract Retroactive tax legislation is constitutional in most high-income countries. In this paper, we are concerned with the fiscal and macroeconomic consequences stemming from retroactive income taxation. Within the context of a real neoclassical economy, we find that if the government can set taxes retroactively within the fiscal year—or if there is a positive probability that a future government will be able to use retroactive taxation—then there exists a multiplicity of expectations-driven equilibria. In this case, neither fiscal policy nor macroeconomic aggregates are uniquely pinned down by economic fundamentals. Rather, they are determined by expectations about current and future fiscal policies. This implies that the government is a source of macroeconomic instability. In contrast, a constitutional reform banning the government from using retroactive tax legislation would yield a unique equilibrium, thus removing the possibility of expectations-driven fluctuations.

Growth and instability in a small open economy with debt

The relationship between public debt, growth and volatility is investigated in a Barro-type (1990) endogenous growth model, with three main features: we consider a small open economy, international borrowing is constrained and households have taste for domestic public debt. Therefore, capital, public debt and the international asset are not perfect substitutes and the economy is characterized by an investment multiplier. Whatever the level of the debt-output ratio, the existing BGP features expectation-driven fluctuations. If the debt-output ratio is low enough, there is also a second BGP with a lower growth rate. Hence, a lower debt does not stabilize the economy with credit market imperfections. However, a high enough taste for domestic public debt may rule out the BGP with lower growth. This means that if the share of public debt held by domestic households is high enough, global indeterminacy does not occur.

Input-output linkages in Pigouvian industrial fluctuations

Input-output linkages facilitate expectations-driven fluctuations. Signals about yet-to-be-realized aggregate (macro) and idiosyncratic (micro) fundamentals in the future affect current equilibrium outcome through chains of input needs when inputs require time to build. Depending on their importance on these chains, firms respond differently to common signals. The network structure, together with input time to build, determines the magnitude of signal-induced aggregate fluctuations. Macro signals need large input shares on average to produce sizable aggregate volatility, whereas micro signals require cross-sectional variations of input importance. Changing input time to build and altering the network structure have similar effects on equilibrium outcomes.

NONSEPARABLE PREFERENCES DO NOT RULE OUT AGGREGATE INSTABILITY UNDER BALANCED-BUDGET RULES: A NOTE

We investigate the role of nonseparable preferences in the occurrence of macroeconomic instability under a balanced-budget rule where government spending is financed by a tax on labor income. Considering a one-sector neoclassical growth model with a large class of nonseparable utility functions, we find that expectations-driven fluctuations occur easily when consumption and labor are Edgeworth substitutes or weak Edgeworth complements. Under these assumptions, an intermediate range of tax rates and a sufficiently low elasticity of intertemporal substitution in consumption lead to instability.

Can firm entry explain news-driven fluctuations?

Most models subjected to news shocks fail to re-produce the basic aggregate comovement facts. This paper proposes that firm entry can be a channel for the real business cycle model to generate quantitatively realistic expectations-driven fluctuations. Endogenous variation in products supports aggregate comovement in response to contemporaneous shocks and news about future technology. This occurs easily even if, as argued by recent empirical studies, markups are procyclical. The model matches the key second moments of U.S. business cycles. The findings highlight the importance of future work on the implications of news-driven firm entry and its interaction with markups for optimal policy.

Fiscal policy, debt constraint and expectations-driven volatility

Imposing some constraints on public debt is often justified regarding sustainability and stability issues. This is especially the case when the ratio of public debt over GDP is restricted to be constant. Using a Ramsey model, we show that such a constraint can however be a fundamental source of indeterminacy, and therefore, of expectations-driven fluctuations. Indeed, through the intertemporal budget constraint of the government, income taxation negatively depends on future debt, i.e. on the expected level of production. This mechanism ensures that expectations on the future tax rate may be self-fulfilling. We show that this is promoted by a larger ratio of debt over GDP.

Rational bubbles and macroeconomic fluctuations: The (de-)stabilizing role of monetary policy

We are interested in the existence of expectation-driven fluctuations of a rational bubble and the (de-)stabilizing role of monetary policy. This paper highlights the key role of credit market imperfections at the household level to explain bubble fluctuations and exhibits the stabilizing power of monetary rules responding to asset prices. We consider an overlapping generations exchange economy where households realize a portfolio choice between money and a bubble. Money is held because of a partial cash-in-advance constraint affected by the size of the bubble. A higher value of the bubble reduces the need of cash, and thus increases the fraction of consumption purchased on credit. Under these credit market features, multiplicity of steady-states (global indeterminacy) and expectation-driven fluctuations (local indeterminacy) can occur for arbitrarily small market distortions. Investing the stabilizing role of monetary policy, we show that when the monetary policy rule responds only to expected inflation, a more active rule can be destabilizing by promoting local indeterminacy and has no impact on the multiplicity of steady states. In contrast to the previous policy, when the rule responds also to asset prices, then the monetary policy can be stabilizing and rule out the multiplicity of steady states.

PUBLIC SPENDING AS A SOURCE OF ENDOGENOUS BUSINESS CYCLES IN A RAMSEY MODEL WITH MANY AGENTS

We introduce public spending, financed through income taxation, into the Ramsey model with heterogeneous agents. Public spending as a source of welfare generates more complex dynamics. In contrast to previous contributions focusing on similar models but with wasteful public spending, limit cycles through Hopf bifurcation and expectation-driven fluctuations appear if the degree of capital–labor substitution is high enough to be compatible with capital income monotonicity. Moreover, unlike frameworks with a representative agent, our results do not require externalities in production and are compatible with a weakly elastic labor supply with respect to wage.

Dynamic two‐country Heckscher–Ohlin model with externality

AbstractWe extend a dynamic Heckscher–Ohlin model with production externality presented in recent work by Nishimura and Shimomura by assuming a consumable capital good. Following work by Bond, Iwasa, and Nishimura, we define a steady‐state excess demand function and derive the locus of home and foreign capital stocks that are consistent with a steady‐state equilibrium under free trade. Also, we examine the relationship between externality and local dynamics in autarky or under free trade, which includes a phase diagram analysis. Then we show that opening trade can generate expectation‐driven fluctuations in a world trade market.

Demography and pollution

In this paper, we consider an OG model with endogenous fertility and pollution externalities. We assume that pollution lowers the productivity. In the long run, under dominant income (substitution) effects, a raise in the cost of rearing children, increases (decreases) consumption and decreases (increases) pollution. In the short run, under dominant income effects, a sufficiently low pollution elasticity of labor productivity promotes deterministic cycles through a Hopf bifurcation jointly with expectations-driven fluctuations.

Aggregate instability under balanced-budget consumption taxes: A re-examination

We re-examine the destabilizing role of balanced-budget fiscal policy rules based on consumption taxation. Using a one-sector model with infinitely-lived households, we consider a specification of preferences derived from Jaimovich (2008) [14] and Jaimovich and Rebelo (2009) [15] which is flexible enough to encompass varying degrees of income effect. When the income effect is not too large, we show that there exists a Laffer curve, which explains the multiplicity of steady states, and that non-linear consumption taxation may destabilize the economy, promoting expectation-driven fluctuations, if the elasticity of intertemporal substitution in consumption is sufficiently larger than one and the tax rate is counter-cyclical with respect to consumption. Numerical illustrations also show that consumption taxation may be a source of instability for most OECD countries for a wide range of structural parametersʼ configurations. We finally prove the robustness of our conclusions if we consider a discrete-time setup.

Countercyclical markups and news-driven business cycles

The standard one-sector real business cycle model is unable to generate expectations-driven fluctuations. The addition of countercyclical markups and modest investment adjustment costs offers an easy fix to this conundrum. The simulated model replicates the regular features of U.S. aggregate fluctuations.

ENDOGENOUS BUSINESS CYCLES IN OVERLAPPING-GENERATIONS ECONOMIES WITH MULTIPLE CONSUMPTION GOODS

We consider an overlapping-generations economy with two consumption goods. There are two sectors that produce a pure consumption good and a mixed good that can be either consumed or used as capital. We prove that the existence of Pareto-optimal expectations-driven fluctuations is compatible with standard sectoral technologies if the share of the pure consumption good is low enough. Following Reichlin's [Journal of Economic Theory 40 (1986), 89–102] influential conclusion, this result suggests that some fiscal policy rules can prevent business-cycle fluctuations in the economy by driving it to the optimal steady state as soon as they are announced.

Stabilizing Balanced-Budget Rule in Economies with Sector-Specific Externalities

It has been argued that a balanced-budget rule exhibiting sufficient fiscal increasing returns creates aggregate instability by generating expectation-driven fluctuations. This paper shows that the assertion crucially depends on the nature of the external effects affecting the technology. By contrast with factor-specific externalities usually studied in the relevant literature, the balanced-budget rule can be used as a stabilization policy to rule out indeterminacy based on sector-specific externalities, provided the discount rate is small enough. The policy is more efficient when government spending is financed by a tax on labor income: stabilization cannot be achieved under an exclusive capital levy. However, capital levy may help in reducing the taxation on labor supply while main- taining stabilization but generates an increase in the tax burden. Consequences for policy prescriptions are discussed.

On the role of progressive taxation in a Ramsey model with heterogeneous households

Abstract The aim of this paper is to study the role of progressive tax rules on the steady state and the stability properties in a Ramsey economy with heterogeneous households and borrowing constraints. Since labor supply is elastic, considering different tax rates on capital and labor incomes matters. Showing the existence of steady states where only the most patient households hold capital, we argue that working could not be optimal for them. Dynamics are addressed through a local analysis. In contrast to many contributions, progressive tax rules can promote expectation-driven fluctuations and endogenous cycles. Hence, progressivity can be an inopportune device to stabilize macroeconomic volatility.

Indeterminacy and expectation-driven fluctuations with non-separable preferences

We consider a continuous-time two-sector infinite-horizon model with sector-specific externalities, endogenous labor and a concave homogeneous non-separable utility function. We show that local indeterminacy arises with a low elasticity of intertemporal substitution in consumption provided the wage elasticity of the labor supply and the elasticity of substitution between consumption and leisure are low enough. Such a result cannot hold with additively separable preferences for which local indeterminacy requires a large enough elasticity of intertemporal substitution in consumption.

Collaterals and macroeconomic volatility

In this paper, we study the effects of collaterals on business cycles and growth in monetary economies with credit market imperfections. We consider an endogenous growth model with a partial cash-in-advance constraint. It is assumed that the share of consumption purchases paid on credit depends positively on the collaterals available to the agent. In this case, money is no longer superneutral. We find that, under mild inflation rates, a higher money growth rate is welfare-improving and, surprisingly, it makes the occurrence of expectations-driven fluctuations less likely. The shape of credit share in consumption purchases, as outcome of regulatory policies, has an impact on both welfare and stability. In particular, the higher the sensitivity of the credit share to collaterals, the more stable the economy under rational expectations. These analytical findings are complemented by economic interpretations.

On rational exuberance

In his seminal contribution, Tirole (1985) shows that an overlapping generations economy may monotonically converge to a steady state with a positive rational bubble, characterized by the dynamically efficient golden rule. The issue we address is whether this monotonic convergence to an efficient long run equilibrium may fail, while the economy experiences persistent endogenous fluctuations around the golden rule. Our explanation leads on the features of the credit market. We consider a simple overlapping generations model with three assets: money, capital and an asset paper, which behaves as a bubble. Collaterals matter because increasing the amount of capital and asset paper in the portfolio, the household reduces the share of consumption paid in cash. From a positive point of view, we show that the bubbly steady state can be locally indeterminate under arbitrarily small credit market imperfections and, thereby, persistent expectation-driven fluctuations of equilibria with (rational) bubbles can arise. From a normative point of view, monetary policies that are not too expansive are recommended in order to rule out the occurrence of sunspot fluctuations and enhance the welfare evaluated at the steady state.

Central Bank Communication and Expectations Stabilization

The value of communication is analyzed in a model in which agents' expectations need not be consistent with central bank policy. Without communication, the Taylor principle is not sufficient for macroeconomic stability: divergent learning dynamics are possible. Three communication strategies are contemplated to ensure consistency between private forecasts and monetary policy strategy: communicating the precise details of policy; communicating only the variables on which policy decisions are conditioned; and communicating the inflation target. The former strategies restore the Taylor principle as a sufficient condition for anchoring expectations. The latter strategy, in general, fails to protect against expectations-driven fluctuations. (JEL E32, E43, E52, E58)

Can heterogeneous preferences stabilize endogenous fluctuations?

While most of the literature concerned with indeterminacy and endogenous cycles is based on the restrictive assumption of a representative consumer, some recent contributions have investigated the role of heterogeneous agents in dynamics. This paper adds to this latter strand of the literature by highlighting the effects of heterogeneity in consumers’ preferences within an overlapping generations economy. Using a mean-preserving approach to heterogeneity, we show that increasing the dispersion of propensity to save decreases macroeconomic volatility, by narrowing down the range of parameter values compatible with indeterminacy and ruling out expectations-driven fluctuations under a sufficiently large heterogeneity.