Government Spending and the Taylor Principle

Abstract

This paper explores how government size affects the scope for equilibrium indeterminacy in a New Keynesian economy, where part of the population live hand‐to‐mouth. The main result is that a higher level of public consumption is likely to generate indeterminacy and render the Taylor principle insufficient as criterion for equilibrium uniqueness. This holds even though fiscal policy serves to reduce swings in current income. Only if government consumption is a substitute for private consumption, will it narrow the scope for indeterminacy. Hence monetary policy should be conducted with an eye to the amount and composition of government consumption.