Income Taxation, Interest-Rate Control and Macroeconomic Stability with Balanced-Budget
This paper studies stabilization effects of fiscal and monetary policy rules in the context of a standard real business cycle model with money. We assume that the fiscal authority adjusts the rate of income tax subject to the balanced-budget constraint, while the monetary authority controls the nominal interest rate by observing inflation. Inspecting macroeconomic stability of the steady state equilibrium of the model economy, we demonstrate that whether or not policy rules eliminate the possibility of sunspot-driven fluctuations critically depends upon the appropriate combination of progressiveness of taxation and activeness of interest-rate control.
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