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Summary of WP/92/102

International Monetary Fund
Published Date:
January 1993
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Summary of WP/92/102

“Inflation and Fiscal Deficits: The Irrelevance of Debt and Money Financing” by José M. Barrionuevo

The experience of many industrial and developing countries suggests that fiscal deficits have introduced significant distortions in the economy without stimulating economic activity. Barro (1974) shows that, under certain conditions, changes in public deficits arising from a switch from tax to bond financing (borrowing) of a given level of real spending will not affect real economic activity. Propositions of this kind are important because they suggest that the only way to stimulate economic activity is by reducing taxes and spending.

Public sector deficits have a bad reputation because, sooner or later, governments will resort to money creation, and hence inflation, to finance them. Sargent and Wallace (1981) and Sargent (1987) discuss deficit financing regimes that are intermediate to the models that use only money or only bonds. In these intermediate regimes, an increase in interest-bearing debt eventually leads to higher inflation because increased debt signals future increases in money. However, these models’ predictions of inflation hinge on the assumption about the time required to balance the government budget. A major drawback of this assumption is the uncertainty about whether the government budget can be balanced in 5, 10, or 20 years.

This paper presents a model that circumvents the requirement of explicitly setting a period for balancing the fiscal budget yet implies that increases in the growth of public debt are bound to increase inflation if there is no perceived commitment to reduce the fiscal deficit. The model represents an economy with no certain time horizon within which the intertemporal government budget is to be balanced. Inferences about whether a fiscal deficit is too high or too low at any given time are drawn from the market’s expected real rate of return. Two special cases of the model are the Sargent and Wallace money and debt financing irrelevance proposition and the quantity theory of money. More importantly, the model introduces a trading pattern that allows a more flexible use of credit and money.

Three irrelevance propositions on the effects on inflation of debt and money financing are presented. The money and debt irrelevance propositions are used to characterize the mechanics of inflation under alternative financing policies. Numerical simulations are used to illustrate and interpret the dynamics of inflation as implied by the alternative financing strategies. A simple example suggests that declines in inflation can be achieved only through strong fiscal reform rather than through isolated tightening of fiscal and monetary policy or price controls.

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