Increasing Returns, Balanced-Budget Rules, and Aggregate Fluctuations

In a seminal contribution, Guo and Harrison (2004, JET) showed that, under a balanced-budget rule, the neoclassical growth model exhibits saddle-path stability when the adjustment is based on wasteful public spending. The present paper challenges this result in an endogenous growth framework with non-trivial dynamics of the debt-to-GDP ratio. We show that the emergence of aggregate instability dramatically depends on the strength of social labor externalities. If the labor demand is positively sloped and steeper than the labor supply, two reachable balanced-growth paths appear-a no growth trap, and a positive growth solution-that gives birth to both local and global indeterminacy, hence aggregate instability driven by self-fulfilling beliefs (sunspots). In addition, we show that a fiscal rule such that the tax rate strongly responds to public-debt increases can remove the no-growth trap, and secure positive long-run growth. JEL classification: E62; O41