Government Financing, Inflation, and the Financial Sector
50 Pages Posted: 15 Feb 2014 Last revised: 27 Mar 2020
Date Written: March 1, 2020
We calculate the effects of an increase in government spending financed with labor income taxes or inflation. Government spending takes the form of government consumption or transfers. Agents increase the use of financial services to avoid losses from inflation. The financial sector increases with inflation, in accordance with the data. In standard cash-in-advance models, in the presence of government transfers, it is optimal to finance the government with inflation. In our framework, it is optimal to use taxes. We reverse the result from standard cash-in-advance models. The reason is the additional costs from the increase in the financial sector.
Keywords: fiscal policy, monetary policy, government financing, demand for money, financial sector
JEL Classification: E52, E62, E63
Suggested Citation: Suggested Citation