Journal of International Economics 105 (2017) 90–101

Contents lists available at ScienceDirect

Journal of International Economics

journal homepage: www.elsevier.com/locate/jie

Balanced-budget income taxes and aggregate stability in a small

open economy
Kevin X.D. Huang a , Qinglai Meng b, * , Jianpo Xue c
a
Department of Economics, Vanderbilt University, Nashville, TN 37235, USA
b
Department of Economics, Oregon State University, Corvallis, OR 97331, USA
c
School of Finance, Renmin University of China, Beijing 100872, China

A R T I C L E I N F O A B S T R A C T

Article history: In a closed economy, a balanced-budget fiscal policy rule with endogenous income tax rates can generate
Received 23 December 2013 aggregate instability due to self-fulfilling expectations (e.g., Schmitt-Grohé and Uribe, 1997). This paper
Received in revised form 20 October 2016 shows, both analytically and numerically, that beliefs-driven aggregate instability associated with such a
Accepted 16 December 2016 balanced-budget rule is less of a problem in a small open economy integrated in the world asset and goods
Available online 23 December 2016
markets. This is because cross-border capital flows and endogenous international price adjustments produce
income effects that reduce the likelihood of sunspot equilibria. From a policy perspective, our results relieve
JEL classification:
possible concerns that balanced-budget rules and reliance on income taxes to achieve budget objective could
E32
have destabilizing effects on the economy.
E62
F11 © 2016 Elsevier B.V. All rights reserved.
F4

Keywords:
Small open economy
Balanced-budget rules
Income taxes
Saddle-path stability
Self-fulfilling expectations
Indeterminacy

1. Introduction
A prominent debate over macroeconomic policy centers on the
question of whether a government should run a balanced budget.
Advocates of a balanced government budget argue that persistent
budget deficits may cause problems for both the economy and the
government, in particular, they may crowd out private investment
and reduce long run growth, and exert financial pressure on the
government’s future budgets and jeopardize its debt sustainability.
Policymakers concerned about excessive deficits often feel the neces-
sity of imposing rules to prohibit or set a limit on fiscal deficits.
This is in fact what is stipulated in the Stability Pact in Europe that
encourages its member countries to achieve balanced budgets.1
Critics of a balanced-budget rule argue that the intrinsically pro-
cyclical nature of such policy (i.e., tax rate cut or government spend-
ing hike in boom but tax rate hike or government spending cut in
bust) may exacerbate economic fluctuations driven by fundamental
shocks, although researchers are also skeptical about the effective-
ness of a counter-cyclical discretionary fiscal policy in stabilizing the
economy given the time required in its formulation and implementa-
tion. In a seminal paper, Schmitt-Grohé and Uribe (1997) present an
additional argument for why a balanced-budget rule may be desta-
bilizing. They show that such policy may induce indeterminacy, and

1
As part of the agreement that created the Euro, the governments of the mem-
* Corresponding author at: Department of Economics, Oregon State University, USA. ber countries signed on to the Stability Pact. The agreement requires that each
E-mail address: meng2008@oregonstate.edu (Q. Meng). government keeps its budget deficit below 3% of the country’s GDP or face fines.

http://dx.doi.org/10.1016/j.jinteco.2016.12.004
0022-1996/© 2016 Elsevier B.V. All rights reserved.
 K. Huang et al. / Journal of International Economics 105 (2017) 90–101
hence expectations-driven fluctuations unrelated to economic fun-
damentals, in an economy whose government relies on adjusting
income tax rates to achieve its balanced-budget objective.
The work by Schmitt-Grohé and Uribe (1997) has spurred a large
body of research on the relation between a balanced-budget rule and
beliefs-driven aggregate instability.2 To the best of our knowledge,
however, all existing studies have examined the issue in a closed
economy. In this paper, we study the issue in a small open econ-
omy (SOE), which is a realistic and necessary extension since most
economies are not closed, but small and open.3
We show, under Schmitt-Grohé and Uribe (1997) type of
balanced-budget rule with endogenous income tax rates, that
beliefs-driven aggregate instability is less of a problem in a SOE inte-
grated in the world asset and goods markets. This is because cross-
border capital flows and endogenous international price adjustments
produce income effects that reduce the likelihood of sunspot equilib-
ria. From a policy perspective, our results relieve possible concerns
that balanced-budget rules and reliance on income taxes to achieve
budget objective could have destabilizing effects on the economy due
to self-fulfilling expectations.
To gain insight into our results, we first elaborate on the reason
for why indeterminacy can occur in a closed economy whose govern-
ment relies on adjusting labor income tax rate to maintain a balanced
budget. We begin by noting that taxation on labor income influences
the price of leisure relative to consumption. Suppose that households
expect the tax rate to be higher. A higher tax rate implies a lower
price of leisure – this would induce the households to cut current
labor supply and consumption. On the other hand, a higher tax rate
implies a lower disposable income – this would induce the house-
holds to raise current labor supply while curtailing consumption.4
This is to say that the income effect and the intratemporal substitu-
tion effect arising from the expected tax rate hike affect labor supply
in opposite directions. Self-fulfilling expectations can happen in a
closed economy like Schmitt-Grohé and Uribe (1997) because the
substitution effect dominates the income effect. Since the labor tax
rate is counter-cyclical, a reduction in labor supply would indeed
render the tax rate to be higher, making the households’ expectations
self-fulfilling.
The above intuition suggests that the net effect of a tax on
labor supply depends on the relative size of the income and sub-
stitution effects and hence on the specification of utility function.
Schmitt-Grohé and Uribe (1997) adopt a separable utility function
that is logarithmic so has a unitary elasticity of intertemporal sub-
stitution (EIS) in consumption. With such preference specification,
when expecting a tax rate hike the increase in households’ labor sup-
ply and decrease in consumption associated with the income effect
are small. This is so because a large increase in labor supply and thus
in investment requires a large reduction in current consumption,
which is impossible with a small EIS. This is why in Schmitt-Grohé
and Uribe (1997) the income effect is small and dominated by the
(intratemporal) substitution effect so indeterminacy prevails. But,
this also suggests that if we replace their preference specification by
a general separable utility function to allow for a sufficiently large
EIS, the relative size of the income and substitution effects could be
2
See, among others, Guo and Lansing (1998), Guo and Harrison (2004, 2008),
Pintus (2004), Gokan (2006, 2008, 2013), Giannitsarou (2007), Dromel and Pintus
(2008), Linnemann (2008), Stockman (2010), Saïdi (2011), Nishimura et al. (2013),
Nourry et al. (2013), Anagnostopoulos and Giannitsarou (2013), and Xue and Yip
(2015).
3
Even in the US, almost all the state governments follow the balanced-budget rules.
4
Wen (2001) provides an intuition about indeterminacy based on households’ per-
manent income. The income effect we refer to here relates to the permanent income
and is intertemporal. The intuition given in the present paper is also motivated by
the insight provided in Giannitsarou (2007) and Anagnostopoulos and Giannitsarou
(2013). See Footnotes 6 and 7 for details.
91
reversed, and this would prevent the households’ expectations from
becoming self-fulfilling. As this paper proves, this is indeed the case.
In a small open economy integrated in the world financial and
goods markets, in expectation of a higher tax rate, the increase in
domestic households’ labor supply and investment can be large due
to the income effects generated by cross-border capital flows associ-
ated with international asset trade and by endogenous international
price adjustments associated with global goods trade, allowing the
households in the SOE more flexibilities than solely relying on cut-
ting their current consumption in financing the needed investment.
In other words, these income effects arise in the SOE because of a
weakened linkage between its production and consumption deci-
sions made possible by its integration with the international capital
and goods markets. In consequence, as this paper demonstrates, the
income effect tends to dominate the substitution effect and thus
self-fulfilling expectations are unlikely to occur in such a SOE.
We establish our results in three steps. Section 2 considers a
closed economy that nests Schmitt-Grohé and Uribe (1997) as a
special case. We prove that a larger EIS implies a greater income
effect which renders indeterminacy less possible; in particular, given
the values of all other parameters, there exists an upper bound for
EIS, above which indeterminacy cannot occur and the steady state
generally exhibits saddle-path stability.
Section 3 considers a small open economy under a balanced-
budget rule with endogenous income tax rates. The aim here is to
show how cross-border capital flows associated with international
asset trade can produce income effect to make indeterminacy less
likely. To isolate such effect of capital market integration, we assume
that all international prices are exogenous and constant for the SOE
so it can borrow or lend freely at a constant world interest rate. We
prove that such perfect integration of the SOE in the world capital
market brings about a dominant income effect that renders inde-
terminacy impossible, regardless of the magnitude of EIS. We show
that, when impediments to international capital mobility are intro-
duced by imposing upon the SOE a debt-elastic interest rate on the
non-contingent international debt, indeterminacy becomes possible
and its likelihood gradually increases with the degree of such world
capital market imperfections.
Section 4 extends the analysis in Section 3 to a small open econ-
omy with multiple tradable goods where all international prices
are determined endogenously. This extension is important, as it
allows the income effects that make indeterminacy less possible to
be generated not only by cross-border capital flows associated with
international asset trade, but also by endogenous international price
adjustments associated with global goods trade. Our results here
reinforce the message that beliefs-driven aggregate instability asso-
ciated with a balanced-budget rule is less of a problem in a SOE
integrated in the world asset and goods markets.
We conclude the paper in Section 5. We aim to streamline the
main text in a concise way so we relegate some technical derivations
or proofs to the appendices.
2. A closed economy
The production side of the closed economy consists of two sec-
tors with one producing consumption goods (y1t ) and the other
producing investment goods (y2t ) according to
a 1−ai
yit = kiti lit , 0 < ai < 1, i = 1, 2, (1)
where kit and lit are the capital and labor inputs and a i is the share
of capital in value added in sector i. Factor markets are perfectly
92 K. Huang et al. / Journal of International Economics 105 (2017) 90–101

competitive, and the first-order conditions for profit maximization 2.1. The case with a 1 = a 2 (≡ a)
are
Similarly as in Schmitt-Grohé and Uribe (1997), the system
y1t y2t y1t y2t reduces to two linearized dynamic equations
wt = (1 − a1 ) = pt (1 − a2 ) , r t = a1 = pt a2 , (2)
l1t l2t k1t k2t
   
q̇t qt − q
where wt and rt are the pre-tax real wage and capital rental rates, and =J . (10)
k̇t kt − k
pt is the relative price of investment goods to consumption goods.
A representative household maximizes the discounted present The trace and determinant for the Jacobian matrix are
value of its lifetime utility,
  q(a + w)(1 − t) + d(1 − a)t
 ∞ 1+w Tr( J) = ,
ct1−s − 1 l −qt w + a − (1 + w)t
− t e dt, s ≥ 0, w ≥ 0, q > 0, (3)
0 1−s 1+w (q + d) (1 − a)
2 2 C(t)
Det ( J) = − , (11)
as w + a − (1 + w)t
where ct and lt are the consumption and hours worked, s is the recip-
rocal of the elasticity of intertemporal substitution in consumption, where
w is the reciprocal of the Frisch elasticity of labor supply, and q is a

subjective discount rate, subject to a series of budget constraint, q + d(1 − a)

C(t) = (1 + w)t2 − w + (1 + s + w) t
(q + d)(1 − a)
ct + pt it + Tt = wt lt + rt kt , (4) q + d(1 − a)
+ (s + w) . (12)
(q + d)(1 − a)
where it and kt are investment and total capital stock, and Tt is
We can establish the following necessary and sufficient condition
labor income tax levied by the government that maintains a balanced
for indeterminacy.
budget each period,

Tt = T1t + T2t = tt wt l1t + tt wt l2t = tt wt lt = G, (5) Proposition 1. In the closed economy where the government follows
the balanced-budget labor income tax rule (5), if a 1 = a 2 ≡ a, then the
equilibrium is indeterminate if and only if 5
here, government expenditure G is pre-set and constant, tt is labor
tax rate, and Tit is tax on labor income earned in sector i, and a series
of law of motion for capital, k̇t = it − dkt . The Hamiltonian is given by t < t < to , (13)

w+a
1+w where t ≡ 1+w , and to ∈ (0, 1) is the solution to the quadratic equation
c1−s − 1 lt
Ht = t − +0t [(1 − tt )wt lt + rt kt − ct − pt it ]+qt (it −dkt ). C(t) = 0.
1−s 1+w
(6)
The case with s = 1 and w = 0 corresponds to the benchmark
model in Schmitt-Grohé and Uribe (1997). While indeterminacy
The market clearing conditions are lt = l1t + l2t , kt = k1t + k2t ,
occurs as long as Eq. (13) holds, it can be shown that, for given values
ct = y1t − T1t , and pt it = pt y2t − T2t .
of all of the other parameters, there exists a lower bound for s below
Appendix A sketches the general equilibrium conditions, where
which indeterminacy cannot occur.
we also show that, if a 1 = a 2 , the model degenerates to a one-sector
setting that nests the one in Schmitt-Grohé and Uribe (1997) as a
special case (i.e., s = 1 ). Corollary 1. For given values of all of the other parameters in the model,
For the case with a 1 = a 2 , we can use Eq. (2) to obtain there exists a lower bound fors, denoted as s, below which either the
dynamic system exhibits saddle path stability or there are no equilibrium
 a1  1−a1  a2 −a
1 solutions, where
l2t 1
a −a a2 1 − a2 1
= mpt 2 1 ≡ x (pt ) , m≡ , (7)
k2t a1 1 − a1 (1 + w)qa + (q + d)(1 − a)2 a
s≡ > 0. (14)
q + d(1 − a) 1−a
−a2
and then write Eq. (5) as G = (1 − a2 )tt lt pt x(pt ) , which together
imply Proof. See Appendix B.
a
ma2 G a2 −a
1
lt = (1 − a2 )0t (1 − tt )pt x(pt )−a2 ,
1 w
pt = tt l t , (8) Note that as the elasticity of intertemporal substitution in con-
1 − a2
sumption is the reciprocal of s, the lower bound of s corresponds
to the upper bound of EIS, above which indeterminacy cannot occur.
where we have also used the intratemporal Euler conditions for con-
For the parameter values used in the benchmark model in Schmitt–
sumption and labor in deriving the last equation. We can use the two
Grohé and Uribe (1997), q = 0.04, d = 0.1, a = 0.33, and w = 0, we
equations in Eq. (8) to express lt and tt as functions of pt and 0t , and
have s = 0.3542 . Obviously, with logarithmic in consumption (i.e.,
use the factor market clearing conditions to express k2t as a function
s = 1) in their paper, the lower bound condition for indeterminacy
of pt , 0t , and kt ,
is satisfied.
a1 (1 − a2 ) l (pt , 0t ) (1 − a1 )a2
k2t = − kt . (9)
a1 − a2 x (pt ) a1 − a2 5
In Eq. (10), as qt is a jump variable and kt is a predetermined variable, indetermi-
nacy happens if the two roots of J are both stable. Saddle-path stability (determinacy)
In what follows, a variable with no time index denotes the steady- occurs if only one root is stable. If the two roots are both unstable, then the system has
state value of that variable. no equilibrium solutions that converge to the steady state.
 K. Huang et al. / Journal of International Economics 105 (2017) 90–101 93

The intuition for the results in Proposition 1 and Corollary 1 is as be analytically shown that determinacy always happens: in this case
follows. Taxation on labor income introduces a distortion that affects the linearized system becomes
the price of leisure in terms of the consumption goods. An increase in
⎛ ⎞
the tax rate decreases the relative price of leisure, reducing both cur-   (1−a2 )(q+d)  
0
rent consumption and labor supply via a substitution effect. But taxa-
q̇t
=⎝
a1 −a2  ⎠ qt − q , (15)
a a d 1−a1 k1 1−a2
k̇t ∗ − a 1−a2 + a kt − k
tion also induces an income effect. If households expect their income 1 2 a1 k2 2

to be lower due to a higher tax rate, they would increase current


labor supply (i.e., reduce leisure) and curtail consumption. Thus the
substitution effect and the income effect influence current labor sup-
ply in opposite directions. In Proposition 1, as in Schmitt-Grohé and
Uribe (1997), self-fulfilling expectations can occur because the sub-
stitution effect dominates the income effect. Since the labor tax rate
is counter-cyclical, a reduction in labor supply would indeed increase
the tax rate, so that the household’s expectations are self-fulfilling.6
But this also suggests that the net effect of a tax on labor sup-
ply depends on the relative size of the substitution and income
effects. If the elasticity of intertemporal substitution in consumption
is small, as in Schmitt-Grohé and Uribe (1997), in expectation of a
tax rate hike, the households are only willing to cut their consump-
tion by a small amount. A large increase in labor supply is impossible
as the corresponding increase in investment would require a large
cut in current consumption. Thus, the income effect is dominated
by the substitution effect. However, the relative size of the income
and substitution effects can be reversed for a sufficiently large EIS
(i.e., a sufficiently small s). In such a case, self-fulfilling expectations
cannot happen.
2.2. The case with a 1 = a 2
When a 1 = a 2 , analytical results cannot generally be obtained.
We thus solve the model numerically. The result on indeterminacy is
similar to that seen in the case with a 1 = a 2 . In Fig. 1, we illustrate
the result by setting the same parameter values as in Schmitt-Grohé
and Uribe (1997) except that we allow a 2 to vary (it also includes the
case with a 1 = a 2 ).7
In addition, for given values of all of the other parameters, it can
be numerically shown that, just as in the case with a 1 = a 2 , there
exists a lower bound for s below which indeterminacy cannot occur
and either the system exhibits saddle-path stability or there exist no
equilibrium solutions that converge to the steady state. Moreover, if
s = 0, i.e., if the elasticity of intertemporal substitution is infinite so
households are indifferent between consuming now and later, it can
1−a )(q+d)
where the two eigenvalues ( a 2−a
a a d
and − a 1−a2
1−a1 k1
+
1−a2
1 2 1 2 a1 k2 a2
have opposite signs, so the equilibrium is always determinate.
The intuition for why indeterminacy cannot occur for a suffi-
ciently small s is the same as for the case with a 1 = a 2 : households
are willing to increase their labor supply by a large magnitude in
expectation of a tax rate hike so that the income effect dominates.
In the next section, we show that the dynamics of a small open
economy with perfect capital mobility resembles that of the closed
economy here with s = 0.
3. A small open economy
We now assume that the economy is small and open. To facil-
itate comparison between the results in this section and those in
the previous section, we retain the two-sector economic structure
and assume that the consumption goods can be traded and the
investment goods cannot be traded.8
As is well known in the literature on small open economy real
business cycle models, the system would have a zero eigenvalue and
hence be nonstationary if, as in the closed economy model, the dis-
count rate were assumed to be a constant.9 Various approaches have
been introduced in the literature to resolve this problem. To help
simplify exposition, we here follow Bian and Meng (2004), who use a
variant of a method proposed in Schmitt-Grohé and Uribe (2003), by
assuming that the discount rate is an increasing function of the econ-
omywide average level of consumption c̄t , which is taken as given
by individual households.10 This entails replacing e −qt in Eq. (3) with
t
e− 0 q(c̄s )ds , where q ( • ) > 0.
At date t, domestic households of the small open economy can
borrow or lend in the world capital market at a real interest rate ht
that they take as given. For comprehensiveness, we consider here the
general case with both labor and capital income taxes so the govern-
ment’s balanced-budget rule takes the following generalized form,
where f t denotes capital tax rate,

6
Schmitt-Grohé and Uribe (1997) illustrate their indeterminacy result by referring
to a Laffer curve, in which the tax revenue is drawn as a function of the steady-state
tax rate and to corresponds to the peak of the curve, under their specification of the
utility function with logarithmic consumption (s = 1) and indivisible labor (w = 0).
Anagnostopoulos and Giannitsarou (2013) provide an insight into why there may exist
such kind of a general connection between the shape and characteristics of the Laffer
curve and indeterminacy under the balanced-budget rule and dependence of labor
supply on tax rate, and this explains the condition in (13), which implies that, for inde-
terminacy to occur there must be a nonempty set for tax rates on the upward-sloping
side of the Laffer curve in (t, to ). We are able to verify their insight under our more
general specification of the utility function by analytically showing that the upper
bound to on tax rate for indeterminacy indeed coincides with the tax rate correspond-
ing to the peak of the Laffer curve for general s and w (the analytical proof of this result
is not presented here due to the space constraint but available upon request from the
authors). This also explains, since the lower bound t on tax rate for indeterminacy is
independent of s but the peak of the Laffer curve shifts to the left as s decreases, why
with a large elasticity of intertemporal substitution in consumption (i.e., when s is
small) the economy might be located on the right side of the Laffer curve even for a
moderate tax rate so the government cannot collect enough revenues by raising tax
rate and self-fulfilling expectations cannot occur (i.e., Corollary 1 and Appendix B).
7 10
The insight given in Anagnostopoulos and Giannitsarou (2013) about a general
connection between the shape and characteristics of a Laffer curve and indetermi-
nacy is also verified for this general case. Our numerical exercise shows that the upper
bound to on tax rate for indeterminacy coincides with the tax rate corresponding to
the peak of the Laffer curve even if a 1 = a 2 . Details of the numerical exercise are not
presented here in order to conserve space but available upon request from the authors.
Tt = tt wt lt + ft rt kt = G, (16)
which nests (5) as a special case (i.e., f t = 0). The household’s budget
constraint becomes
ḋt = ht dt − (1 − tt ) wt lt − (1 − ft ) rt kt + ct + pt it , (17)
where dt is the household’s net international debt position. The
Hamiltonian in Eq. (6) is modified accordingly. Other features of the
model remain the same as in Section 2.
8
The analysis in this section focuses on the case with a 1 = a 2 in order to conserve
space. Similar results can be obtained for the case with a 1 = a 2 , which can be recast
as a one-sector model.
9
It is also known as the knife-edge property of the steady state. The zero root
problem in continuous time models corresponds to the unit root problem in discrete
time setups, which are used in the small open economy literature.
Making a discount rate dependent on the average levels of some variables instead
of individual variables can considerably simplify the analysis. We could have directly
followed Schmitt-Grohé and Uribe (2003) to make the discount rate a function of the
average level of not only consumption but also hours worked, and our basic conclu-
sion would not change. See also Shi (1999) and Meng (2006) for other examples using
similar approaches.
94 K. Huang et al. / Journal of International Economics 105 (2017) 90–101

Fig. 1. The closed economy model: D - determinacy, I - indeterminacy, N - no equilibrium.

The model’s equilibrium system can be reduced to the following Thus the Jacobian matrix has a lower triangular form, and its four
four dynamic equations eigenvalues are

  1 − a2
ṗt = pt ht + d − a2 [1 − f (pt , 0t )] x(pt )1−a2 , (18) j11 = (h + d) ,
a1 − a2
cq (c)

  j22 =− ,
−1/s s
0̇t = 0t q 0t − ht , (19)  
1 − a1 da1 (1 − a2 )
j33 =− h [1 − (1 − a2 )t]+d(1 − a2 )(1 − t)+ ,
a1 − a2 1 − a1
j44 = h.
k̇t = [1 − (1 − a2 )t (pt , 0t ) − a2 f (pt , 0t )] x(pt )1−a2 k2 (pt , 0t , kt )−dkt ,
(20) Since j22 < 0, j44 > 0, j11 and j33 have opposite signs, and there
are two jump variables and two predetermined variables, the system
is always determinate.
ḋt = ht dt − [1 − (1 − a1 )t (pt , 0t ) − a1 f (pt , 0t )] k1 (pt , 0t , kt )a1
− s1
× l1 (pt , 0t , kt )1−a1 + 0t , (21) Proposition 2. In the small open economy with perfect international
capital mobility where the government follows the balanced-budget
labor income tax rule (5) , the dynamic system exhibits saddle-path
where we have used the first-order conditions for profit maximiza-
stability.
tion, and for utility maximization with respect to consumption and
labor, the factor market clearing conditions, and the government
budget constraint with the endogenous labor and capital income tax We now show our determinacy result for the case that the gov-
rates varying in the same proportional, in deriving those implicit ernment follows the more general balanced-budget rule (16). When
functions in the above system, and where we have also used the fact both labor and capital income tax rates are endogenous and vary
that c̄t = ct in equilibrium. in the same proportion and labor is indivisible, Schmitt-Grohé and
Uribe (1997) find numerically that indeterminacy still arises in their
3.1. With perfect international capital mobility closed-economy model. In the small open economy model with
perfect capital mobility and with indivisible labor, we can prove ana-
We first consider the case where international capital mobility is lytically that the system is determinate. The proof entails showing
perfect in the sense that domestic households can borrow and lend that, in this case, the Jacobian matrix for the 4 × 4 linearized sys-
freely in the world capital market at an exogenously given and con- tem in the two jump and two predetermined variables, pt , 0t , kt , and
stant real interest rate ht = h. We show below that in this case dt , again takes a lower triangular form and, of the four eigenvalues,
indeterminacy can never occur. j22 < 0 and j44 > 0, and
We first prove our determinacy result analytically for the case
that the government follows the balanced-budget labor income tax (h + d) [a1 (1 − t) + (1 − a2 )(1 − f)]
j11 = − ,
rule (5). The linearized system in this case is given by (a2 − a1 )(1 − f)
 
(1−a1 )t+a1 f k1 (1−a2 )t+a2 f
⎛ ⎞ + da1 a2
⎛ ⎞⎛ ⎞ a1 k2 a2
ṗt j11 0 00 pt − p j33 = ,
⎜ 0̇ ⎟ (a2 − a1 )t
⎜ 0 0 ⎟ ⎜ ⎟
⎜ t
⎜
⎟ ⎜
⎟=⎝
j22 0 ⎟ ⎜ 0t − 0 ⎟ . (22)
⎝ k̇t ⎠ ∗ ∗ j33 0 ⎠ ⎝ kt − k ⎠ which always have opposite signs. This shows that the system
ḋt ∗ ∗ ∗ j44 dt − d exhibits saddle-path stability.
 K. Huang et al. / Journal of International Economics 105 (2017) 90–101
Proposition 3. In the small open economy with perfect international
capital mobility, and with indivisible labor (i.e., w = 0), where the gov-
ernment follows the balanced-budget rule (16) , the dynamic system
exhibits saddle-path stability.
For the case that w = 0 and the government follows the balanced-
budget rule (16), transparent analytical expressions for eigenvalues

of the linearized system are hard to obtain. We have thus appealed to
numerical exercises in confirming that indeterminacy cannot occur
even in this more general case.
We have conducted other sensitivity analyses to investigate how
robust our determinacy result is. For instance, in their closed econ-
omy model, Schmitt-Grohé and Uribe (1997) find that under the
balanced budget rules indeterminacy also arises in cases when the
labor income tax rate is endogenous and the capital income tax rate
is exogenous or when both tax rates are endogenous and government
purchases are income-elastic. They further extend their indetermi-
nacy result to the case with public debt. For all of these cases, we find
that indeterminacy cannot happen in the small open economy with
perfect international capital mobility.


We have done many more robustness checks under perfect
international capital mobility than could be reported here due
to space constraint, and found that our basic determinacy result
holds generally in various extensions to our baseline setting in this
section, including cases with (i) a general utility function, (ii) both
traded and nontraded capital goods, (iii) multiple traded goods, or
(iv) combinations of these cases.11
The take-home message from the above analyses is that indeter-
minacy cannot occur in the small open economy under a balanced-
budget rule, with perfect international capital mobility. We provide
here some intuition behind this result. As noted in Section 2, in
the closed economy, indeterminacy cannot occur when the elas-
ticity of intertemporal substitution is large, since in this case the
income effect dominates the substitution effect. In the small open
economy with perfect international capital mobility, self-fulfilling
expectations cannot happen because the income effect produced by
cross-border capital flows associated with international asset trade
dominates the substitution effect, independent of the size of EIS. In
expectation of higher tax rates, the increase in households’ labor sup-
ply and the needed investment in capital goods can be large, as the
households can always borrow from the outside world at a given
and constant real interest rate to finance the new investment. As
this effect dominates the substitution effect, labor supply increases,
and the tax rates turn out to be lower, destroying self-fulfilling
expectations.
3.2. With imperfect international capital mobility
In Section 3.1, the small open economy is assumed to have a per-
fect access to the world capital market in the sense that it can borrow
from or lend to the rest of the world at a given and constant real
interest rate. In such a case indeterminacy and self-fulfilling expec-
tations can be ruled out. On the other hand, the case of a closed
economy examined in Section 2 and Schmitt-Grohé and Uribe (1997)
in which indeterminacy can arise could be recast as an open economy
under financial autarky where borrowing from or lending to the rest
of the world is never allowed or forbiddingly costly. In this section,
we consider an intermediate case between the two extremes, where
domestic households face an imperfect world capital market, to
study the sensitivity of the results in Section 3.1 to varying degrees
of integration of the SOE in the world capital market.12
11
These additional results are available upon request from the authors.
12
We are grateful to two anonymous referees for suggesting that we examine this
intermediate case.
95
Following some of the literature on small open economy mod-
els (e.g., Schmitt-Grohé and Uribe (2003)), we model world capital
market imperfections by assuming that the interest rate faced by
domestic households, ht , is increasing in the average level of the
country’s outstanding debt, denoted by d̄t and taken as given by
individual households.13 Specifically, ht is here given by
ht = h + y d̄t , y ( • ) > 0, (23)
where h is a fixed world interest rate as in Section 3.1, and y( • ) is a
country-specific interest-rate risk premium that is meant to capture
world capital market imperfections.
Transparent analytical demonstrations are hard to show for this
case, so in what follows we focus on showing our results numerically.
To do so, we need to assign values to the model’s parameters. We set
q(c) = 0.04, h = 0.04, d = 0.1, s = 1, w = 0, and d = 0.7442, as
in Schmitt-Grohé and Uribe (1997, 2003), and we choose a 1 = 0.33
and a 2 = 0.3. Next we parameterize y( • ) following Schmitt-Grohé
and Uribe (2003):
y d̄t = c ed̄t −d − 1 , (24)
where c ≥ 0 governs the elasticity of the interest rate faced by the
country with respect to changes in its indebtedness, thus a greater
value of c implies a greater degree of world capital market imper-
fections. This is a key parameter for our analysis in this section. We
consider 0.00074 as a benchmark value for c following the calibra-
tion of Schmitt-Grohé and Uribe (2003) based on Canadian data, but
at the same time we examine how varying the value of c may affect
our determinacy result.
We find that indeterminacy indeed becomes possible in the
presence of world capital market imperfections and its likelihood
increases with the degree of such imperfections. Fig. 2 illustrates this
for the case when the government follows the balanced-budget labor
income tax rule (5). The figure shows that indeterminacy becomes
possible when c becomes positive, and the range of the steady-state
labor income tax rate for which indeterminacy occurs widens with c.
Fig. 3 further demonstrates this for the case that the govern-
ment follows the more general balanced-budget rule (16). As the
figure shows, the configurations of the steady-state labor and capi-
tal income tax rates under which indeterminacy occurs constitute a
nonempty set if c is positive, and the set becomes larger as c gets
bigger. To get some empirical feel, the figure also displays the pairs of
labor and capital income tax rates estimated by Mendoza et al. (1997)
for eleven developed small open economies, including Austria (AT),
Australia (AU), Canada (CA), Denmark (DK), Finland (FI), Netherlands
(NL), Norway (NO), New Zealand (NZ), Spain (SP), Sweden (SE), and
Switzerland (SZ). As can be seen from the figure, for the benchmark
value of c, there are no countries for which the tax rate pairs fall
into the indeterminacy region. For larger c, some countries may fall
into the indeterminacy region. For example, were c four times bigger
than its benchmark value, the indeterminacy region would expand
to include three of the eleven countries.
Given what are shown for the two extremes, the results here
are intuitive to explain. The case with c = 0 is the one extreme
examined in Section 3.1, in which cross-border financial flows amid
perfect international capital mobility produce a dominant income
effect that renders self-fulfilling expectations simply impossible (for
all admissible values of elasticity of intertemporal substitution in
consumption). This is because when households expect higher tax
rates, they can increase labor supply sufficiently and borrow from
13
Similar results can be obtained if we instead assume that the households face a
cost of holding or issuing bonds.
96 K. Huang et al. / Journal of International Economics 105 (2017) 90–101

Fig. 2. The small open economy model with imperfect international capital mobility under the balanced-budget labor income tax rule: D - determinacy, I - indeterminacy,
N - no equilibrium.

abroad at a fixed interest rate to finance the needed capital goods,
without cutting much of their current consumption.
As c increases from 0, the world capital market becomes less per-
fect for the SOE and the income effect associated with cross-border
financial flows is weakened. Since in this case adding more invest-
ment goods to cope with increased labor supply by borrowing from
overseas can quickly become very costly, households would increase
less of their labor supply when expecting tax rate hikes, unless they
are willing to cut more of their current consumption, which would be
the case if and only if the EIS is relatively large. In fact, for any given
value of c, one can always find a value of EIS above which indeter-
minacy can never happen. Such lower bound on EIS is simply 0 for
c = 0, and is given by the inverse of s in Corollary 1 for c = ∞, as
this latter extreme corresponds to the closed economy examined in
Section 2. Clearly, as c approaches ∞, the income effect produced by
cross-border capital flows due to international asset trade will vanish
completely.
4. An open economy with endogenous terms of trade
We now extend the analysis in Section 3 to a small open econ-
omy with multiple tradable goods where all international prices are
determined endogenously. We show that, in such a SOE, the income

Fig. 3. The small open economy model with imperfect international capital mobility under the balanced-budget labor and capital income tax rule: D - determinacy,
I - indeterminacy.
 K. Huang et al. / Journal of International Economics 105 (2017) 90–101 97

effects that render indeterminacy less possible can be generated not PH,t [(1 − tt )wt lt + rt kt ] − Pt zt , where zt can be either consumed (ct )
only by cross-border capital flows arising from international asset or invested (it ) and the law of motion for capital is kt+1 = (1 −
trade, but also by endogenous international price adjustments due d)kt + it . Note that labor income tax levied by Home government that
to global goods trade.14 Our results in this section solidify the key maintains a balanced budget is given by Tt = tt wt lt = G, where gov-
message that beliefs-driven aggregate instability associated with a ernment spending G is pre-set and constant, and the labor tax rate
balanced-budget rule is less of a problem in a SOE integrated in the tt is endogenous. The market  clearing condition for Home-produced 
PH,t −g g
world asset and goods markets. goods is yt − Tt = Pt [1 − (1 − n) a] zt + [(1 − n) a∗ ] et zt∗ .
The SOE model examined in this section can be viewed as a lim- We now focus on the case that Home is a small open economy by
iting case of the workhorse two-country international business cycle taking n → 0 so l → 1 − a and l ∗ → 1. In this SOE, the relationship
model that typically adopts a discrete-time setting. We thus proceed between real exchange rate and Home terms of trade becomes
by first setting up a discrete-time two-country open economy model
(e.g., Corsetti et al., 2008), and then focusing our analysis on the case −(1−g) −(1−g)
where the home country is a small open economy. In what follows, et = (1 − a ) s t + a, (25)
a notation for the foreign country (i.e., the rest of the world) is super
indexed by a star, and a variable with a hat and time index denotes the prices of Home and Foreign aggregate consumption bundles
the percentage deviation of that variable from its steady state.   1
1−g 1−g 1−g
become Pt = (1 − a) PH,t + aPF,t and Pt∗ = PF,t
∗
, respectively,
For the general two-country setup, we assume that the world
economy consists of Home and Foreign, each producing tradable St Pt∗ et Pt
of which the latter implies st = PH,t = PH,t , which can be used to
intermediate goods using a Cobb-Douglas technology. The produc- show
tion function for Home goods is given by yt = kat l1−a t , where
a ∈ (0, 1), and kt and lt are Home capital and labor inputs. Home Pt st   1
1−g 1−g
households combine Home produced goods yH,t and Foreign pro- = = (1 − a) + ast ≡ v (st ) , (26)
PH,t et
duced goods yF,t to fabricate Home final goods according to zt =
  g
g−1 g−1 g−1
1 g 1 g and the market clearing condition for Home-produced goods
l g yH,t + (1 − l ) g yF,t , where g ∈ (0, ∞) , and l = 1 − (1 − n)a
becomes
is the relative weight of Home-produced goods in the composite,
yt − Tt = (1 − a) v(st )g zt + a∗ st zt∗ .
g
which is a function of the relative size of the Home economy, n, (27)
and the degree of its trade openness, a ∈ (0, 1) . Let PH,t , PF,t , and
Pt be the prices of Home produced goods, Foreign produced goods, As we show in Appendix C, local determinacy analysis of this SOE
and Home final goods, all denominated in Home currency units. Cost
−g −g boils down to examining a system of four dynamic equations. Given
P P
minimization yields yH,t = l PH,t
t
zt , yF,t = (1 − l ) PF,tt zt , and the complexity of the system, transparent analytical results are hard
  1 to obtain, so in what follows we focus on showing our results numer-
1−g 1−g 1−g ∗ ∗
Pt = lPH,t + (1 − l ) PF,t . Let PF,t , PH,t , and Pt∗ be the prices ically. To fix parameter values, we set a = 0.33, b = 0.96, d = 0.1,
of Foreign produced goods (y∗F,t ), Home produced goods (y∗H,t ), and s = 1, w = 0, 4c = −0.5, 4l = 0, as in Schmitt-Grohé and Uribe
Foreign final goods (zt∗ ), all denominated in Foreign currency units, (1997, 2003), and g = 0.5, as in Corsetti et al. (2008).
and l ∗ = 1 − na∗ , where a∗ ∈ (0, 1) is the degree of Foreign’s trade Fig. 4 displays the range of the steady-state labor income tax rate
openness. Foreign production side can be described in a parallel way. (t) for different degrees of openness (a) of the small open economy
Let St be the nominal exchange rate measured by the price of For- under which (in)determinacy occurs.
eign currency in units of Home currency. We assume that the law As the figure shows, indeterminacy is less likely to occur, as the
of one price holds for both Home- and Foreign-produced goods so economy becomes more open to the rest of the world. Importantly,
∗ ∗ S P∗ in light of the labor tax rates estimated by Mendoza et al. (1997)
PH,t = St PH,t and PF,t = St PF,t . The real exchange rate et ≡ tPt t
P St P ∗ for developed small open economies, most OECD countries have
and Home terms of trade st ≡ P F,t = P F,t can be shown to satisfy
   H,t H,t
 a labor income tax rate less than 40%, with the OECD average at
1−g 1−g −1
et −(1−g) = l + (1 − l ) st (1 − l ∗ ) + l ∗ s t . 33.459% (for the period 1965–1991): 25.36% for the US, 25.488% for
the UK, 23.273% for Canada, 21.328% for Japan, 39.69% for France,
A Home household’s expected lifetime utility is given by
 1−s
∞ ct −1
1+w
lt and 36.832% for Germany. As can be seen from the figure, if labor
E0 t=0 nt 1−s − B 1+w , where n0 = 1 and nt+1 = income tax rate is less than 42%, then the economy exhibits saddle-

path stability, regardless of the degree of its openness. The result
b c̄t , l̄t nt with b1 < 0 and b2 > 0, and ct is consumption of Home
is robust to alternative values of the model’s parameters within
final goods. To avoid the non-stationarity problem of the net foreign their empirically plausible ranges – for instance, when the trade
asset position, we follow much of the literature on open economy elasticity g, a key parameter that may matter for the result quantita-
business cycle models with incomplete international asset markets tively, takes a higher value – further relieving possible worries about
(e.g., (Corsetti et al., 2008)) to assume an endogenous discount factor indeterminacy.
that is a function of the average per capita level of consumption c̄t The above results show the importance of extending our analysis
and hours worked l̄t , which are taken as given by individual house- to a small open economy with endogenous terms of trade in order
holds even though ct = c̄t and lt = l̄t in equilibrium. Traded on to explore the implications of endogenous international price adjust-
international asset market is a non-contingent bond denominated in ments that impinge on the core mechanism of indeterminacy. As we
Home currency, and denoted by Bt+1 the quantity of the bond pur- have shown above, in such a setting, the income effects that make
chased by the Home household at date t that will be paid off at date indeterminacy less likely to occur can be generated not only through
t + 1 and Dt the price of the bond. Noting that PH,t yH,t + PF,t yF,t = Pt zt , cross-border capital movements due to international asset trade, but
the household faces a sequence of budget constraints, Dt Bt+1 − Bt = more importantly, by endogenous terms-of-trade and other interna-
tional price adjustments associated with global goods trade. These
income effects make beliefs-driven aggregate instability less of a
14
We are grateful to Giancarlo Corsetti (the editor) for suggesting that we examine problem in a SOE integrated in the world asset and goods markets.
our results in such a SOE. From a policy perspective, our results relieve possible concerns that
98 K. Huang et al. / Journal of International Economics 105 (2017) 90–101

Fig. 4. The small open economy model with endogenous terms of trade: D - determinacy, I - indeterminacy.

balanced-budget rules and reliance on income taxes to achieve bud- the Fundamental Research Funds for the Central Universities and the
get objective could have destabilizing effects due to self-fulfilling Research Funds of Renmin University of China.
expectations.
Appendix A. Equilibrium solution for the closed economy

5. Conclusion The first-order conditions for utility maximization are

We have shown that, in contrast to the message from the exist- ct−s = p−1
t qt ,
ing closed economy studies, possible worries about self-fulfilling
lt = (1 − tt )wt p−1
w
expectations and beliefs-driven aggregate instability associated with t qt ,

a balanced-budget fiscal policy rule with endogenous income tax q̇t = qt (q + d − p−1
t rt ).
rates can be largely relieved for a small open economy because of
the resultant income effects. According to our analysis in the present The goods market clearing conditions are
paper, the income effects that make sunspot expectations unlikely
to occur can be generated through cross-border capital movements  
a 1−a1 l1t 1−a1
arising from international asset trade as well as by endogenous ct = k1t1 l1t − T1t = [1 − (1 − a1 )tt ] k1t ,
k1t
terms-of-trade and other international price adjustments due to  1−a2
global goods trade. From a policy perspective, the results of this a 1−a2 l2t
pt it = pt k2t2 l2t − T2t = [1 − (1 − a2 )tt ] k2t .
paper suggest that if the fiscal authority relies on changes in income k2t
tax rates to achieve budget balance, then integrated world capital
and goods markets can play a crucial role in stabilizing the economy. If a 1 = a 2 , the system reduces to the following two dynamic
The conclusion of this paper is based on local analysis. Stockman equations about qt and kt ,
(2010) shows that global indeterminacy could still occur even in

1−a2
the presence of local determinacy in a closed economy model à la q̇t = q + d − a2 m1−a2 p(qt , kt ) a2 −a1 qt ,
Schmitt-Grohé and Uribe (1997). It would be worthwhile to conduct
1−a2
global analysis to examine the robustness of the local results that
k̇t = m1−a2 [1 − (1 − a2 )t (qt , kt )] p(qt , kt ) a2 −a1 k2 (qt , kt ) − dkt .
we have obtained in an open economy setting in this paper. Also,
since as this paper reveals relative price movements can impinge on
the core mechanism of indeterminacy, and as is well known from If a 1 = a 2 ≡ a, then pt = 1, and the system collapses to that in
existing literature nominal rigidities may have implications for rela- the one-sector closed economy model,
tive price movements, it is important to extend our analysis in this 
paper to a setting with nominal rigidities. We intend to leave these q̇t = q + d − aka−1
t l1−a
t qt ,
investigations to future research.
k̇t = kat l1−a
t − dkt − ct − G,

Acknowledgments where ct , lt , and tt are functions of qt and kt solved from the following
first-order conditions,
We are grateful to two anonymous referees, Jang-Ting Guo,
Morten Ravn, the audiences at various institutions and conferences, ct−s = qt ,
and especially Giancarlo Corsetti, the editor, for his very helpful com- lt = (1 − a)(1 − tt )qt kat l−a
w
t ,
ments and suggestions. Huang acknowledges financial support from
the Grey Fund at Vanderbilt University. Xue’s work is supported by G = (1 − a)tt kat l1−a
t .
 K. Huang et al. / Journal of International Economics 105 (2017) 90–101 99

Appendix B. Proof of Corollary 1 If s < s, then C (t) < 0 and C(0) > 0, and there exists a to ∈ (0, t).
It then follows that indeterminacy can never occur:
We first notice that to must lie inside the interval (t, 1) in
order for the indeterminacy condition to hold. Since C(1) =
qa (i) If the steady-state value t ∈ (t, 1) (which is a necessary con-
− (s+w)(q+d)(1−a) < 0 and t < 1, indeterminacy requires C (t) > dition for Tr( J) < 0), then C(t) < 0 and D( J) < 0. The system
0, which immediately implies that there exists a lower bound is determinate.
s for s, (ii) If t ∈ (0, t) (i.e., t−a
1−t < w), then Tr( J) > 0. Either the system
is determinate, if 0 < t < to (as D( J) < 0), or there exist no
(1 + w)qa + (q + d)(1 − a)2 a equilibrium solutions, if to < t < t (as D( J) > 0).
s >s ≡ > 0,
q + d(1 − a) 1−a
Thus, for s < s, the system is determinate if t ∈ (0, to ) ∪ (t, 1),
that is necessary for indeterminacy. and there are no equilibrium solutions if t ∈ (to , t).

Appendix C. Equilibrium solution for the small open economy with endogenous terms of trade

Home firms’ first-order conditions for cost minimization imply

 a  1−a
kt yt lt yt
wt = (1 − a ) = (1 − a ) , rt = a =a .
lt lt kt kt

Home households’ first-order conditions for utility maximization imply

Pt
ct−s = 0t ,
PH,t
w
Blt = (1 − tt ) 0t wt ,
Pt
qt = 0t ,
PH,t
0t   0 
t+1
Dt = b c̄t , l̄t Et ,
PH,t PH,t+1

qt = b c̄t , l̄t Et [0t+1 rt+1 + (1 − d) qt+1 ] .

Home and Foreign households’ first-order conditions for consumption and bond holdings give rise to the following international risk sharing
condition
   
 cts Pt  ct∗s Pt et
b c̄t , l̄t Et s = b c̄t∗ , l̄∗t Et ∗s .
ct+1 Pt+1 ct+1 Pt+1 et+1

The above equilibrium conditions hold for the general two-country setup. For the case that Home is a small open economy, we can show
that there is a symmetric steady state (assuming a = a∗ ) around which the log-linearized equilibrium system consists of the following 13
equations

ŷt = a k̂t + (1 − a)l̂t ,


ŵt = a k̂t − l̂t ,

r̂t = (1 − a) l̂t − k̂t ,

t̂t + ŵt + l̂t = 0,

   
i i
ẑt = 1 − ĉt + ît ,
z z
k̂t+1 = dît + (1 − d)k̂t ,
−s ĉt = 0̂t + ŝt − êt ,
t
w l̂t = − t̂t + 0̂t + ŵt ,
1−t
q̂t = 0̂t + ŝt − êt ,
 
q̂t = 4c ĉt + 4l l̂t + [1 − b(1 − d)] êt+1 − ŝt+1 + r̂t+1 + q̂t+1 ,
êt+1 − s ĉt+1 = êt − (s + 4c )ĉt − 4l l̂t ,
êt = (1 − a)ŝt ,
1
ŷt = (1 − a)(ẑt − gêt ) + gŝt .
1 − (1 − a)t
100 K. Huang et al. / Journal of International Economics 105 (2017) 90–101

We then use q̂t = −s ĉt , êt = (1 − a)ŝt , 0̂t = w l̂t + 1−t t

t̂t − ŵt , ŷt = a k̂t + (1 − a)l̂t , ŵt = a(k̂t − l̂t ), r̂t = (1 − a)(l̂t − k̂t ), and
t̂t = −ŵt − l̂t = −[a k̂t + (1 − a)l̂t ] to write the above into a 6-equation system

   
i i
ẑt = 1 − ĉt + ît ,
z z
k̂t+1 = dît + (1 − d)k̂t ,
   
a−t a
−s ĉt = w + l̂t − k̂t + aŝt ,
1−t 1−t
 
s ĉt+1 − (s + 4c )ĉt − 4l l̂t = [1 − b(1 − d)] −aŝt+1 + (1 − a)(l̂t+1 − k̂t+1 ) ,

s ĉt+1 − (s + 4c )ĉt − 4l l̂t = (1 − a)(ŝt+1 − ŝt ),

1  
a k̂t + (1 − a)l̂t = (1 − a)ẑt + ga(2 − a)ŝt .
1 − (1 − a)t

By introducing two notations, bd ≡ 1 − b(1 − d) and at ≡ 1

1−(1−a)t
, which imply iz ≡ i
z = abdat bd −1 , and using ẑt = (1 − iz )ĉt + iz ît , we
reduce the 6 -equation system above into a 5-equation one,

k̂t+1 = d ît + (1 − d)k̂t ,
   
a−t a
−s ĉt = w + l̂t − k̂t + aŝt ,
1−t 1−t
 
s ĉt+1 − (s + 4c )ĉt − 4l l̂t = bd −aŝt+1 + (1 − a) l̂t+1 − k̂t+1 ,
 
s ĉt+1 − (s + 4c )ĉt − 4l l̂t = (1 − a) ŝt+1 − ŝt ,
   
at a k̂t + (1 − a)l̂t = (1 − a) (1 − iz )ĉt + iz ît + ga(2 − a)ŝt .

With three more notations, cs ≡ − sa , cl ≡ − w

s − s(1−t) , and ck ≡
a−t a
s(1−t)
, and using ĉt = cs ŝt + cl l̂t + ck k̂t and ît = 1
d k̂t+1 − 1−d
d k̂t , we further
simplify the 5-equation system into a 3-equation one,

(1 − a + abd ) ŝt+1 − bd (1 − a)l̂t+1 + bd (1 − a)k̂t+1 = (1 − a)ŝt ,

(scs − 1 + a) ŝt+1 + scl l̂t+1 + sck k̂t+1 = [(s + 4c )cs − 1 + a] ŝt + [(s + 4c )cl + 4l ] l̂t + (s + 4c )ck k̂t ,

(1 − a)iz (1 − d)(1 − a)iz

− k̂t+1 = [(1 − a)(1 − iz )cs + ga(2 − a)] ŝt + [(1 − a)(1 − iz )cl − at (1 − a)] l̂t + (1 − a)(1 − iz )ck − at a − k̂t .
d d

Bt
Denote by b̃t ≡ PH,t y the difference of Home borrowing as a fraction of Home output from its (zero) steady-state value. We use Home
households’ budget constraint and first-order conditions for consumption and bond holdings to obtain bb̃t+1 − b̃t = ŷt − at−1 (ŝt − êt + ẑt ),
which gives rise to a fourth equation

iz a + (1 − iz )cs (1 − iz )cl (1 − iz )ck (1 − d)iz

k̂t+1 + bb̃t+1 = − ŝt + 1 − a − l̂t + a − + k̂t + b̃t .
at d at at at at d

The above four equations form the following dynamic system in the four variables, ŝt , l̂t , k̂t , and b̃t ,

⎛ ⎞⎛ ⎞
1 − a + abd −bd (1 − a) bd (1 − a) 0 Et ŝt+1
⎜ sc − 1 + a scl sck 0⎟ ⎜ ⎟
⎜ s ⎟ ⎜ Et l̂t+1 ⎟
⎜ ⎟⎜ ⎟
⎝ 0 0 − (1−a)i
d
z
0 ⎠ ⎝ Et k̂t+1 ⎠
iz
0 0 at d b Et b̃t+1
⎛ ⎞⎛ ⎞
1−a 0 0 0 ŝt
⎜ (s + 4c )cs − 1 + a (s + 4c )cl + 4l (s + 4c )ck 0⎟ ⎜ ⎟
⎜ ⎟ ⎜ l̂t ⎟
=⎜ ⎟⎜ ⎟
⎝ az cs + ga(2 − a) az cl − at (1 − a) az ck − at a − (1−d)(1−a)i
d
z
0 ⎠ ⎝ k̂t ⎠
(1−i )c (1−i )c
− a+(1−i
at
z )cs
1 − a − atz l a − atz k + (1−d)iat d
z
1 b̃t

where we have introduced another auxiliary notation az ≡ (1 − a)(1 − iz ). Since there are two predetermined variables (k̂t and b̃t ) and two
jump variables (ŝt and l̂t ), the system is indeterminate if it has more than two stable roots, exhibits saddle-path stability (determinacy) if it has
exactly two stable roots, or has no equilibrium solutions that converge to the steady state if it has less than two stable roots.
 K. Huang et al. / Journal of International Economics 105 (2017) 90–101 101

References Mendoza, E., Milesi-Ferretti, G.M., Asea, P., 1997. On the ineffectiveness of policy in
altering long-run growth: Harberger’s superneutrality conjecture. J. Public Econ.
66, 99–126.
Anagnostopoulos, A., Giannitsarou, C., 2013. Indeterminacy and period length under
Meng, Q., 2006. Impatience and equilibrium indeterminacy. J. Econ. Dyn. Control. 30,
balanced budget rules. Macroecon. Dyn. 17, 898–919.
2671–2692.
Bian, Y., Meng, Q., 2004. Preferences, endogenous discount rate, and indeterminacy in
Nishimura, K., Nourry, C., Seegmuller, T., Venditti, A., 2013. Destabilizing bal-
a small open economy model. Econ. Lett. 84, 315–322.
anced-budget consumption taxes in multi-sector economies. Int. J. Econ. Theory
Corsetti, G., Dedola, L., Leduc, S., 2008. International risk sharing and the transmission
9, 113–130.
of productivity shocks. Rev. Econ. Stud. 75, 443–473.
Nourry, C., Seegmuller, T., Venditti, A., 2013. Aggregate instability under bal-
Dromel, N.L., Pintus, P.A., 2008. Are progressive income taxes stabilizing? J. Pub. Econ.
anced-budget consumption taxes: a re-examination. J. Econ. Theory 148,
Theory 10, 329–349.
1977–2006.
Giannitsarou, C., 2007. Balanced budget rules and aggregate instability: the role of
Pintus, P., 2004. Aggregate Instability in the Fixed-cost Approach to Public Spending.
consumption taxes. Econ. J. 117, 1423–1435.
University of Aix-Marseille Working Paper.
Gokan, Y., 2006. Dynamic effects of government expenditure in a finance constrained
Saïdi, A., 2011. Balanced-budget rule, distortionary taxes and aggregate stability. Int. J.
economy. J. Econ. Theory 127, 323–333.
Econ. Theory 7, 293–300.
Gokan, Y., 2008. Alternative government financing and aggregate fluctuations driven
Schmitt-Grohé, S., Uribe, M., 1997. Balanced-budget rules, distortionary taxes, and
by self-fulfilling expectations. J. Econ. Dyn. Control. 32, 1650–1679.
aggregate instability. J. Polit. Econ. 105, 976–1000.
Gokan, Y., 2013. Indeterminacy, labor and capital income taxes, and nonlinear tax
Schmitt-Grohé, S., Uribe, M., 2003. Closing small open economy models. J. Int. Econ.
schedules. J. Macroecon. 36, 138–149.
61, 163–185.
Guo, J.T., Harrison, S.G., 2004. Balanced-budget rules and macroeconomic (in)stability.
Shi, S., 1999. Fashion and wealth accumulation. Econ. Theory 14, 439–461.
J. Econ. Theory 119, 357–363.
Stockman, D.R., 2010. Balanced-budget rules: chaos and deterministic sunspots. J.
Guo, J.T., Harrison, S.G., 2008. Useful government spending and macroeconomic
Econ. Theory 145, 1060–1085.
(in)stability under balanced-budget rules. J. Pub. Econ. Theory 10, 383–397.
Wen, Y., 2001. Understanding self-fulfilling rational expectations equilibria in real
Guo, J.T., Lansing, K., 1998. Indeterminacy and stabilization policy. J. Econ. Theory 82,
business cycle models. J. Econ. Dyn. Control. 25, 1221–1240.
481–490.
Xue, J., Yip, C.K., 2015. Balanced-budget rules, elasticity of substitution and macroeco-
Linnemann, L., 2008. Balanced budget rules and macroeconomic stability with
nomic (in)stability. J. Pub. Econ. Theory 17, 196–218.
non-separable utility. J. Macroecon. 30, 199–215.