Master Thesis by Jiao Jie   
August 19, 2005

Abstract:

Slight departures from standard real business cycle models may lead the economy to display indeterminacy under perfect foresight. In a discrete-time version of the one-sector growth model, the economy may exhibit increasing returns-to-scale due to externality. In such an economic context, the paper involves the government with the following fiscal policy instruments, subsidies on capital income and labor income, and government debt, into consideration. The study shows that a constant labor income subsidy/tax rate and the debt level have no affect on the economy’s stability property, because the labor subsidy rate and the debt adjustment parameter do not enter an inter-temporal tradeoff that affects the public’s self-fulfilling rational expectations. By contrast, a constant capital subsidy rate may lead the economy to a saddle equilibrium, or endogenous fluctuations, or explosiveness. Joint influence of capital subsidy rate with the degree of increasing returns-to-scale, the inter-temporal elasticity of substitution in labor supply and the discount factor may lead the economy to various stability properties, saddle, sink or source. Thus the government’s attempt of using a constant capital tax rate to avoid sunspot fluctuations may fail due to the model’s property of global indeterminacy.