Balanced-Budget Rules and Aggregate Instability: The Role of Endogenous Capital Utilization

Abstract

It has long been demonstrated that in a closed economy a balanced-budget fiscal policy can induce aggregate instability unrelated to economic fundamentals. The empirical relevance of this result has been challenged by many studies. In this paper, we show that such extrinsic instability associated with a balanced-budget rule is a robust phenomenon in a similar closed-economy setting enhanced with endogenous capital utilization. This suggests that the design or operation of a balanced-budget fiscal policy should recognize that it may constitute a potential source of self-fulfilling prophecies and belief-driven fluctuations.