Working Paper: CEPR ID: DP397
Authors: Seppo Honkapohja; Urho Lempinen
Abstract: In this paper we develop a stochastic monetary growth model with exogenous productivity shocks to consider the effects of changes in the financing structure of government deficits on the key variables of the economy. We study how the presence of supply-side uncertainty affects the equilibrium of the economy and the responses of key variables to the various policy changes. Finally, we consider the feasibility of different policies in the model. Introducing uncertainty in the model lowers (raises) the nominal interest rate and the mean inflation rate in the economy, if the fundamental government budget is in deficit (surplus). Changes in the bonds-to-money ratio turn out to have both real and nominal effects in the model. A permanent open market sale is a contractionary measure with respect to output and growth but unambiguously raises the equilibrium nominal interest rate and most likely accelerates inflation.
Keywords: deficits; growth; open-market operations
JEL Codes: 023; 311; 321
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| supply-side uncertainty (D89) | nominal interest rate (E43) |
| supply-side uncertainty (D89) | mean inflation rate (E31) |
| bond-to-money ratio (E43) | output (C67) |
| bond-to-money ratio (E43) | growth (O40) |
| bond-to-money ratio (E43) | nominal interest rate (E43) |
| permanent open market sale (L17) | output (C67) |
| permanent open market sale (L17) | nominal interest rate (E43) |
| permanent open market sale (L17) | inflation (E31) |