Money, Government Deficits

and Inflation

Macroeconomı́a II
Maestrı́a en Economı́a
UTDT

Francisco J. Ciocchini

fciocchini@utdt.edu

2023

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Model
I Money Demand
+
Mtd
Pt
= ( i t, Y t)
I Fisher Equation
Et Pt+1
1 + it = (1 + rt ) Pt
I Assume:

Yt = Y 8t

rt = r 8t
I Then:
⇣ ⌘
Mtd Et Pt+1
Pt
= Pt

⇣ ⌘ ⇣ ⌘
Et Pt+1 Et Pt+1
where Pt
⌘ (1 + r) Pt
1, Y .

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Model
I For simplicity, we assume that the function is linear:
Mtd Et Pt+1
Pt
=c b Pt

with c > b > 0.

I Equilibrium requires:
Mtd = Mt
where Mt is the money supply.
I Then:
Mt Et Pt+1
Pt
=c b Pt

I From the previous expression we get:

Mt
Pt = c
+ ↵Et Pt+1
b
where ↵ ⌘ c
2 (0, 1).

I The expression above is a first-order stochastic linear di↵erence equation

in the price level.
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Price Level
I We can solve Pt = Mt
c
+ ↵Et Pt+1 forward:

Mt
Pt = c
+ ↵Et Pt+1

Mt Mt+1
= c
+ ↵Et { c
+ ↵Et+1 Pt+2 }

= Mt
c
+ ↵
E Mt+1
c t
+ ↵2 Et Et+1 Pt+2

= Mt
c
+ ↵
E Mt+1
c t
+ ↵2 Et Pt+2 by LIE

Mt+2
= Mt
c
+ ↵
E Mt+1
c t
+ ↵ 2 Et { c
+ ↵Et+2 Pt+3 }

↵2
= 1
c
Mt + ↵
E Mt+1
c t
+ c
Et Mt+2 + ↵3 Et Et+2 Pt+3

= 1
c
(Mt + ↵Et Mt+1 + ↵2 Et Mt+2 ) + ↵3 Et Pt+3

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Price Level

I If we keep iterating forward we get:

Pt = 1c (Mt + ↵Et Mt+1 + ↵2 Et Mt+2 + ... + ↵n Et Mt+n ) + ↵n+1 Et Pt+n+1

I Then:
n
X
Pt = 1
c
↵i Et Mt+i + ↵n+1 Et Pt+n+1
i=0

I Letting n ! 1 :

1
X
Pt = 1
c
↵i Et Mt+i + lim ↵n+1 Et Pt+n+1 (1)
n!1
i=0

P1 Pn
where i=0 ↵i Et Mt+i ⌘ lim i=0 ↵i Et Mt+i .
n!1

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Fundamental Solution
I Suppose the price level satisfies
-"solucion sin busbugas"
lim ↵n Et Pt+n = 0
n!1

I Then, 1 becomes:
1
X
Pt⇤ = 1
c
↵i Et Mt+i (2)
i=0

I This particular solution is called the fundamental solution.

I From now on we use a ⇤ to denote the fundamental solution.
I See Appendix I for solutions that display bubbles.

I The expression above shows that the price level at t depends on the
money supply expected to prevail from t into the indefinite future.

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Fundamental Solution
I According to equation 2, government deficits can only influence the path
of the price level through their e↵ect on the expected path of base money.

I However, the government deficit and the path of base money are not
rigidly linked in any immutable way.

I The reason is that the government can, at least to a point, borrow by

issuing interest-bearing government debt, and so need not necessarily
issue base money to cover its deficit.

I To see this more precisely we need to write down the budget constraint of
the consolidated government:
Mt Mt 1
Gt + rt 1 Dt 1 = Tt + (Dt Dt 1) + Pt
(3)

I We assume the public debt is denominated in goods (real bonds).

I See Appendix II for a derivation of this budget constraint.

I Under the system formed by equations 2 and 3, the inflationary

consequences of government deficits depend sensitively on the
government’s strategy for servicing the public debt.
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Equilibrium I

I We consider first a regime in which government deficits have no e↵ects on

the rate of inflation.

I In this regime, the government always finances its entire deficit or surplus
by issuing or retiring interest-bearing government debt.

I Then:
Mt Mt 1 = 0 8t
and
Gt + rt 1 Dt 1 = Tt + (Dt Dt 1) 8t

I From Mt Mt 1 = 0 8t we get:

Mt = M 8t

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Equilibrium I
I With Mt = M 8t, 2 becomes:

1
X
Pt⇤ = 1
c
↵i E t M
i=0

1
X
= 1
c
↵i M
i=0

1
X
= M
c
↵i
i=0

M 1
= c 1 ↵

I Then:
Pt⇤ = 1
(1 ↵)c
M

I Hence, Pt⇤ is constant and proportional to M .

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Equilibrium I

I From Gt + rt 1 Dt 1 = Tt + (Dt Dt 1) we get:

Tt G t Dt
Dt 1 = 1+rt 1
+ 1+rt 1

I Shifting the expression above one period ahead:

Tt+1 Gt+1 Dt+1

Dt = 1+rt
+ 1+rt

I Taking conditional expectations in both sides of the expression above:

n o
Tt+1 Gt+1 Dt+1
Et Dt = Et 1+rt
+ 1+rt

n o
Tt+1 Gt+1 Dt+1
Dt = Et 1+rt
+ 1+rt

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Equilibrium I
I Iterating forward on the previous expression we get:

n o
Tt+1 Gt+1 Dt+1
Dt = Et 1+rt + 1+rt

n ⇣ ⌘o
Tt+1 Gt+1 Tt+2 Gt+2 Dt+2
= Et 1+rt + 1
1+rt 1+rt+1 + 1+rt+1

n o
Tt+1 Gt+1 Tt+2 Gt+2 Dt+2
= Et 1+rt + (1+rt )(1+rt+1 )
+ (1+rt )(1+rt+1 )

n ⇣ ⌘o
Tt+1 Gt+1 Tt+2 Gt+2 Tt+3 Gt+3 Dt+3
= Et 1+rt + (1+rt )(1+rt+1 )
+ 1
(1+rt )(1+rt+1 ) 1+rt+2 + 1+rt+2

8 Tt+1 Gt+1 Tt+2 Gt+2 Tt+3 Gt+3 9

>
< 1+rt + (1+rt )(1+rt+1 )
+ (1+rt )(1+rt+1 )(1+rt+2 )
+ >
=
= Et
>
: Dt+3 >
;
(1+rt )(1+rt+1 )(1+rt+2 )

...
8 Tt+1 Gt+1 Tt+2 Gt+2 Tt+n+1 Gt+n+1 9
>
< 1+rt + (1+rt )(1+rt+1 )
+ ... + (1+rt )(1+rt+1 )...(1+rt+n ) >
=
= Et
>
: + Dt+n+1 >
;
(1+r t )(1+rt+1 )...(1+rt+n )

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Equilibrium I

I Then:
n
X n o
T Gt+j+1
Dt = E t t+j+1
Rtj
+ Et 1
Rtn
Dt+n+1
j=0

where Rtj ⌘ (1 + rt )(1 + rt+1 )...(1 + rt+j ). With rt constant, Rtj = (1 + r)j+1 .

I Now let n ! 1 and set lim Et { R1 Dt+n+1 } = 0. Then:

tn
n!1

1
X T Gt+j+1
Dt = Et t+j+1
Rtj
j=0

I lim Et { R1 Dt+n+1 } = 0 follows from the optimal behavior of the private sector.
n!1 tn

I In this regime, a positive value of interest-bearing government debt signals

a positive expected present discounted value of primary surpluses.

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Equilibrium I
I Substituting the expression above into Dt 1 = Tt G t
1+rt 1
+ Dt
1+rt 1
we get:

1
X T Gt+j+1
(1 + rt 1 )Dt 1 = (Tt G t ) + Et t+j+1
Rtj
j=0

I In this regime, government deficits have no e↵ects on the price path

because they are permitted to have no e↵ects on the path of base money.

I For the path of base money to be una↵ected by government deficits, it is

necessary that government (primary) deficits be temporary and be
accompanied by exactly o↵setting future government surpluses (as shown
by the previous expression).

I A possible interpretation of this regime is that there is monetary

dominance: the Central Bank chooses its monetary-policy instrument
exogenously, and the Treasury passively adjusts fiscal policy in order to
satisfy the budget constraint of the government.
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Equilibrium II
I There are alternative debt-servicing strategies under which government
deficits are inflationary.
I To take an example at the opposite pole from the previous regime,
consider the following rule:
Dt = 0 8t
I Then, equation 3 becomes:
Mt Mt 1
Gt Tt = Pt

I According to this rule, deficits are always to be financed entirely by issuing

additional base money, with interest-bearing government debt never being
issued.

I In this regime, the time path of government deficits a↵ects the time path
of the price level in a rigid and immediate way that is described by the
budget constraint above and the equation for Pt⇤ , 2.

I Under this regime it is possible for the government budget to be

persistently in deficit, within limits imposed by the budget constraint and
the money-demand equation. Deficits need not be temporary.
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Equilibrium II
I As a simple example, suppose that the primary deficit is exogenous and
constant:
Gt Tt = 8t
with > 0.

I This requires a constant seigniorage:

Mt Mt 1
Pt
= 8t

I We guess that there is an equilibrium with a constant growth of the

Mt Mt 1
money supply µt ⌘ Mt 1
:

µt = µ 8t

I Then, Mt+1 = (1 + µ)Mt 8t )

Mt+i = (1 + µ)i Mt

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Equilibrium II
I Substituting Mt+i = (1 + µ)i Mt in 2:

1
X
Pt⇤ = 1
c
↵i Et (1 + µ)i Mt
i=0

1
X
Mt
= c
[↵(1 + µ)]i
i=0

I Assuming ↵(1 + µ) < 1 :

Pt⇤ = 1
c[1 ↵(1+µ)]
Mt

I Remark: ↵(1 + µ) < 1 ) c[1 ↵(1 + µ)] = c b(1 + µ) > 0; hence, real
balances are positive when ⇡ = µ.

I Then:
⇡t = µ 8t

Pt Pt 1
where ⇡ t ⌘ Pt 1 is the inflation rate between t 1 and t.

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Equilibrium II

I To determine the equilibrium value of µ we need to go back to the budget

constraint:
Mt Mt 1 Mt M t 1 M t 1
= Pt
= Mt 1 Pt

Mt 1 Mt µt Mt
= µt Mt P t
= 1+µt Pt

I Then:
µ
= 1+µ
[c b(1 + µ)]

I From the expression above we can solve for µ.

I In this particular case we get a quadratic equation than can be solved in
closed form.
I When equilibrium exists (i.e., when is not too large), we obtain multiple
equilibria. See the figure below.

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Equilibrium II

I Equilibria

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Equilibrium II
I Increase in
I If the economy is in the increasing part of the La↵er curve for
seigniorage, an increase in the fiscal deficit leads to higher money
growth and higher inflation.

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Equilibrium II

I As previously claimed, this is a regime in which government deficits are

inflationary.

I A possible interpretation of this regime is that there is fiscal dominance:

the Treasury chooses fiscal policy exogenously, and the Central Bank
passively adjusts monetary policy in order to satisfy the budget constraint
of the government.
I Notice that fiscal dominance has a limit imposed by the requirement of
equilibrium existence: is exogenous, but it cannot be too large.

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Appendix I: Bubbles
I The equation we want to solve is:
Mt
Pt = c
+ ↵Et Pt+1

with ↵ 2 (0, 1).

I We have already shown that:
1
X
Pt = 1
c
↵i Et Mt+i + lim ↵n+1 Et Pt+n+1
n!1
i=0

I We want a solution with:

lim ↵n+1 Et Pt+n+1 6= 0

n!1

I We propose the following candidate:

Pt = Pt⇤ + Bt

where Pt⇤ is the fundamental solution, and Bt is an unspecified random variable

(a bubble).

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Appendix I: Bubbles
I Now we check under what conditions (if any), Pt = Pt⇤ + Bt is a solution.
I For Pt = Pt⇤ + Bt to be a solution it must satisfy our original equation,
Mt
Pt = c
+ ↵Et Pt+1 . Hence, we need:

Pt⇤ + Bt = Mt
c
⇤
+ ↵Et {Pt+1 + Bt+1 }

I Then:
Pt⇤ + Bt = Mt
c
⇤
+ ↵Et Pt+1 + ↵Et Bt+1

I But we know the fundamental solution satisfies the original equation:

Pt⇤ = Mt
c
⇤
+ ↵Et Pt+1

I Combining the previous two expressions we get:

Bt = ↵Et Bt+1

I Hence, Pt = Pt⇤ + Bt will be a solution as long as the random variable Bt

(the bubble) satisfies the condition above.
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Appendix I: Bubbles
I From Bt = ↵Et Bt+1 we get:

Et Bt+1 = 1
B
↵ t
1
↵
>1

I Then:
Et+1 Bt+2 = 1
B
↵ t+1
I Then:

Et Et+1 Bt+2 = Et { ↵1 Bt+1 }

Et Bt+2 = 1
EB
↵ t t+1
by LIE

Et Bt+2 = 1 1
B
↵ ↵ t

Et Bt+2 = 1
B
↵2 t

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Appendix I: Bubbles
I Also:
Et+2 Bt+3 = 1
B
↵ t+2
I Then:

Et Et+2 Bt+3 = Et { ↵1 Bt+2 }

Et Bt+3 = 1
EB
↵ t t+2
by LIE

Et Bt+3 = 1 1
B
↵ ↵2 t

Et Bt+3 = 1
B
↵3 t

I If we continue with this iterative process we get:

Et Bt+n = 1
B
↵n t

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Appendix I: Bubbles

I Then:

lim Et Bt+n = lim 1n Bt

n!1 n!1 ↵

1
= Bt lim n
n!1 ↵

8
< +1 if Bt > 0
=
:
1 if Bt < 0

I Notice that the bubble is explosive.

I The case with lim Et Bt+n = 1 reflects the limitation of our

n!1
assumption that the money-demand function is linear.

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Appendix I: Bubbles
I For the sake of completeness, we can check that lim ↵n+1 Et Pt+n+1 6= 0
n!1
whenever there is a bubble (Bt 6= 0).

I Using Pt = Pt⇤ + Bt we get:

lim ↵n+1 Et Pt+n+1 ⇤

= lim ↵n+1 Et {Pt+n+1 + Bt+n+1 }
n!1 n!1

⇤
= lim ↵n+1 Et Pt+n+1 + lim ↵n+1 Et Bt+n+1
n!1 n!1
| {z }
=0

= lim ↵n+1 E t Bt+n+1

n!1

1
= lim ↵n+1 ↵n+1 Bt
n!1

= lim Bt
n!1

= Bt

6= 0 whenever Bt 6= 0

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Appendix I: Bubbles

I Example

I Suppose
Mt = M 8t
and {Bt } satisfies
1
Bt+1 = B
↵ t
+ ⌘ t+1

where {⌘ t+1 } is a zero-mean iid sequence of shocks.

I Notice that:
Et Bt+1 = 1
B
↵ t
+ Et ⌘ t+1

1
= B
↵ t

I Then, Pt = Pt⇤ + Bt is a solution with Pt⇤ = 1

M and
(1 ↵)c
1
Bt = B
↵ t 1
+ ⌘t .

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Appendix I: Bubbles
I Example (cont.)

I Simulation

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Appendix I: Bubbles
I Bursting Bubbles

I Now suppose:
8 1
< B
↵p t
+ ⌘ t+1 with probability p
Bt+1 =
:
0 with probability 1 p

where p 2 (0, 1) and {⌘ t+1 } is a zero-mean iid sequence of shocks.

I From the expression above we get:

n o
1
Et Bt+1 = pEt B
↵p t
+ ⌘ t+1 + (1 p)Et {0}

1
Et Bt+1 = p ↵p Bt + pEt ⌘ t+1

1
Et Bt+1 = B
↵ t

I Hence, the random variable Bt qualifies as a bubble.

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Appendix I: Bubbles
I Bursting Bubbles (cont.)

I Example of a bursting bubble with fundamental solution Pt⇤ = 1

M.
(1 ↵)c

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Appendix II: Budget Constraint
I In this appendix we derive the budget constraint of the consolidated
government from the budget constraints of the Treasury and the Central
Bank.

I Treasury (T)
I Budget constraint:

Gtt + rt t
1 Dt 1 = Tt + (Dtt Dtt 1) + Vt

I Central Bank (CB)

I Balance Sheet:
Dtt,cb Mt /Pt
Dtcb
N Wt
I Budget constraint:
cb cb t,cb t,cb t,cb cb cb Mt Mt 1
Gt + Vt + rt 1 Dt 1 + (Dt Dt 1
) = rt 1 Dt 1 + (Dt Dt 1
)+ Pt

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Appendix II: Budget Constraint
I Consolidated Government

I Combining the budget constraints of T and CB:

Gtt + rt t
1 Dt 1 + Gcb
t + Vt + rt
cb
1 Dt 1 + (Dtt,cb Dtt,cb1 ) =

t,cb Mt Mt
Tt + (Dtt Dtt 1) + V t + rt 1 Dt 1 + (Dtcb Dtcb 1 ) + Pt
1

I Then:
(Gtt + Gcb
t ) + rt
t
1 (Dt 1 Dtt,cb1 + Dtcb 1 ) =

Mt Mt
Tt + (Dtt Dtt,cb + Dtcb ) (Dtt 1 Dtt,cb1 + Dtcb 1 ) + Pt
1

I Then:
Mt Mt 1
G t + rt 1 Dt 1 = Tt + Dt Dt 1 + Pt

where
Gt ⌘ Gtt + Gcb
t

Dt ⌘ Dtt Dtt,cb + Dtcb

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Bibliography

I Blanchard, Olivier (1979). “Speculative Bubbles, Crashes and Rational

Expectations,” Economics Letters, Vol. 3, No. 4, pp. 387-389.

I Sargent, Thomas (2013). “Rational Expectations and the Reconstruction

of Macroeconomics,” Chapter 1 in Rational Expectations and Inflation,
3rd Edition, Princeton University Press.

I Sargent, Thomas (2013). “Reaganomics and Credibility,” Chapter 2 in

Rational Expectations and Inflation, 3rd Edition, Princeton University
Press.

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