Fiscal Policy, Adjustment Costs and Endogenous Growth

This paper introduces convex adjustment costs into an endogenous growth model of a closed economy. In doing so our focus will be on analyzing the effects of fiscal policy on the long-run growth performance of the economy. This is a particularly important application of these models, since few economists would deny that fiscal policy has important consequences for long-run economic growth. Yet the traditional Ramsey model, with its long run growth rate being determined by demographic factors, (and independent of the usual macroeconomic policy instruments), is incapable of addressing these issues satisfactorily. We will study an economy in which government raises taxes to finance expenditures. These expenditures are assumed to be directed to enhancing the productive activities of the economy. In this respect, the government expenditure will play two roles. In the first place, it will impact directly on production conditions and enhance the productivity of the existing capital stock. This effect has received increasing attention in the literature, both with respect to its empirical relevance and its theoretical consequences.