Working Paper: CEPR ID: DP1513
Authors: Marcus H. Miller; Lei Zhang
Abstract: Using a variant of the Cagan model with rational expectations, this paper shows that expected stabilization can result in a budget deficit in excess of the maximum inflation tax. A cap on the deficit dampens inflation expectations and raises real balances, thus increasing the yield of the inflation tax for any given rate of inflation. This study extends the work of Drazen and Helpman (1990) by including a stochastic budgetary process and using option pricing theory. It uses parameter values of the semi-elasticity of demand for money to provide estimates of the maximum viable real deficit.
Keywords: seigniorage; hyperinflation; fiscal stabilization; stochastic deficits
JEL Codes: E31; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected stabilization (C62) | inflation expectations (E31) |
| inflation expectations (E31) | budget deficit exceeding maximum inflation tax yield (E62) |
| cap on the deficit (H62) | dampen inflation expectations (E31) |
| dampen inflation expectations (E31) | raise real balances (E49) |
| raise real balances (E49) | enhance the yield of the inflation tax (H26) |
| budget deficits (H62) | exceed steady-state yields without triggering currency collapse (F31) |