Balanced-budget fiscal rules and money growth pegging

This paper analyzes the interaction between monetary policy rule and distortionary balanced-budget tax policy rules on the stability properties of a one-sector Ramsey economy. The demand of money is motivated by a fractional cash-in-advance constraint on consumption expenditures. The monetary authority pegs the money growth factor while the fiscal authority uses a distortionary income tax or a distortionary consumption tax to balances its budget. Without or with distortionary taxes, we find a unique steady state and characterize its stability. The local stability of the unique steady state, when without distortionary taxes, depends on the interplay between the share of the liquidity constraint and the intertemporal elasticity of substitution of consumption. Regardless of the distortionary tax’s implementation, we demonstrate that the introduction of a balanced-budget rule, could promote or reduce self-fulfilling expectations, which depends on the amplitude of the liquidity constraint and the slope of the tax schedule. Monetary variables tend to reduce the likelihood of local indeterminacy while fiscal instruments tend to increase it when the slope of the tax schedule is positive. Finally, based on plausible empirical values, we present a simple numerical example considering countercyclical tax rates and show that, for both income and consumption tax rates, the introduction of balanced-budget fiscal rules could be stabilizing.