Government Financing in an Endogenous Growth Model with Financial Market Restrictions

Abstract

In this paper we develop an endogenous growth model with market regulations on explicitly modeled financial intermediaries to examine the effects of alternative government financing schemes on growth, inflation, and welfare. We find that in the presence of binding legal reserve requirements, a marginal increase in government spending need not result in a reduction in the rate of economic growth if it is financed with an increase in the seigniorage tax rate. Raising the seigniorage tax base by means of an increase in the reserve requirement retards growth and has an ambiguous effect on inflation. An increase in income tax?financed government spending also suppresses growth and raises inflation although not to the extent that the required seigniorage tax rate alternative would. Switching from seigniorage to income taxation as a source of government finance is growth-reducing but deflationary. From a welfare perspective, the least distortionary way of financing an increase in the government spending requirements is by means of a marginal increase in the seigniorage tax rate. Finally, under the specification of logarithmic preferences, the optimal tax structure is indeterminate.

Key words: government financing, endogenous growth, financial intermediaries

JEL Classification: E62, E44, O42