Government Financing, Inflation, and the Financial Sector
INOVA Faculdade de Economia Working Paper Series No. 621
32 Pages Posted: 1 Mar 2018
Date Written: January 2018
We calculate the effects of an increase in government spending financed with labor income taxes or inflation. We consider government spending in the form of government consumption or transfers. We use a model in which agents increase the use of financial services to avoid losses from inflation, as empirically the financial sector increases with inflation. The financial sector size is constant in standard cash-in-advance models, which implies optimal positive inflation. We reverse this result when we take into account the increase in the financial sector. In our framework, it is optimal to use taxes to finance the government. This result is robust to alternative specifications and definitions of seigniorage and government spending.
Keywords: fiscal policy, monetary policy, government financing, demand for money, financial sector
JEL Classification: E52, E62, E63
Suggested Citation: Suggested Citation