Stagflationary Effect of Government Bond Financing in the Transforming Chinese Economy: A General Equilibrium Analysis

Abstract

This paper studies how the method of government debt financing affects the macroeconomic performance of the transforming Chinese economy. The investigation is conducted within the context of an endogenous growth model that incorporates the major institutional features of the Chinese economy. Using this framework, we evaluate the effects on the growth rate of output and inflation if the Chinese government relies more on bonds and less on money creation for budget deficit and debt repayment financing. It is shown that although this policy change can reduce the growth rate of the money supply, it can generate a stagflationary effect: reducing the rate of output growth while raising the rate of inflation, if the initial fraction of government deficit and debt repayment financed by bonds is sufficiently small and the tax rate on labor income is sufficiently low.

Keywords: Economic Transformation, Government Debt Finance, Endogenous Growth Model, Stagflationary Effect, The Chinese Economy

JEL Classification: E6, O4, P2