The failure of stabilization policy: Balanced-budget fiscal rules in the presence of incompressible public expenditures

We consider an infinite horizon neoclassical model with a government that (i) balances its budget at each point in time, (ii) faces unavoidable (incompressible) public expenditures, and (iii) further uses a fiscal rule for the share of variable government spending in output with the purpose of stabilizing the economy. We show that insulating this economy from belief driven fluctuations is not possible if the government finances these two components of public spending using a distortionary proportional income tax. In this case, we always have steady state multiplicity (two steady states) and global indeterminacy, while local indeterminacy is also possible. More precisely, even if a sufficiently procyclical share of the variable government spending component in output is still able to eliminate local indeterminacy, two saddle steady states prevail, so that, depending on expectations, the economy may either converge to the low steady state or to the high steady state. This implies that a regime switching rational expectation equilibrium, where the economy switches between paths converging to the two different steady states, easily arises. As expectations influence long run outcomes, our model is able to generate large and sudden expansions and contractions in response to expectation shocks.