Deficits, Crowding Out and Inflation: The Simple Analytics

Abstract

The paper studies the relationship between public sector financial deficits, crowding-out of public sector capital formation and inflation in a number of small, classical macroeconomic models. This amounts to reworking some of the government budget constraint literature by including capacity constraints, flexible prices and rational expectations. After considering some simple "money only' and "money-capital" models, most ofthe paper is devoted to the analysis of a continuous time representation of the "money-bonds-capital" model of Sargent and Wallace. It is noted that the conventionally measured deficit is likely to be a poor indicator both of the "eventual monetization" implied by the fiscal stance and of the long-run financial crowding-out pressure it represents. A better measure would be the inflation-and-real-growth-corrected, cyclically adjusted ("permanent")government currect account deficit as a proportion of national income.It is also suggested that the Sargent-Wallace "paradox" - in the variable velocity model ,lower monetary growth now may mean higher inflation now and in the future -has its counterpart in the possibility that lower money growth now may give lower inflation now and in the future. In the constant velocity model the Sargent-Wallace findings are confirmed when the real interest rate is made endogenous.