Working Paper: NBER ID: w2006
Authors: Allan Drazen; Elhanan Helpman
Abstract: We consider a model in which the level of taxes and seignorage are too low to finance government expenditures and debt service. Government debt will therefore grow without bound, implying the eventual need to change policy. Starting with utility maximization, we analyze the effect of the expected switch on equilibrium time paths before the switch takes place. We analyze stabilization via increasing taxes, increasing money growth rates, or cutting expenditures, both under certainty and under uncertainty about the composition or timing of a stabilization. Under full certainty, inflation may rise, fall, or remain constant before the stabilization, depending on which policy tool is used to stabilize. Uncertainty solely about the composition of the stabilization will yield paths in between the above cases, with a price jump at the time of stabilization. In general there is no simple correlation between changes in the budget deficit and inflation. With uncertainty about the timing OF a stabilization, the inflation rate will most likely exhibit fluctuations and may overshoot its steady state value, even when real balances move monotonically. Uncertainty about the timing of a stabilization can therefore itself induce fluctuation in inflation, even if underlying utility and subjective probability functions are smooth.
Keywords: inflation; macroeconomic policy; government debt; stabilization policies
JEL Codes: E31; E62; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in the rate of monetary growth (O42) | monotonically increasing inflation rate (E31) |
| increase in the rate of monetary growth (O42) | monotonically declining level of real balances (E41) |
| increased non-distortionary taxes (H29) | maintain constant real balances and inflation (E31) |
| stabilization via budget cuts (E63) | eventually reduce inflation (E31) |
| public expectations regarding stabilization policies (E63) | correlation between inflation and budget deficits (E62) |
| uncertainty regarding timing of the switch (C41) | inflation rate exhibits fluctuations (E31) |
| uncertainty regarding timing of the switch (C41) | inflation may overshoot steady state value (E31) |
| anticipated regime switch (E63) | induce rapid changes in inflation rates (E31) |
| price jumps (D49) | occur both before and after stabilization efforts (C62) |
| budget deficit (H62) | drives inflation (E31) |