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Government budgetary policies, economic growth, and currency substitution in a small open economy

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  • Jill A. Holman
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    Abstract

    This paper compares the macroeconomic consequences of alternative government budgetary policies in a small open economy where agents transact in both domestic and foreign currencies. An endogenous growth model is used to rank the effects of income-tax-financed and inflation-tax-financed government expenditures on the economy’s growth and inflation rates. Currency substitution provides an avenue for inflation-tax evasion and affects the rankings of the two modes of government finance. The analysis reveals that an increase in the size of government reduces the growth rate of the economy regardless of the government’s budgetary policy. Inflation taxes hinder growth more than income taxes. Income-tax financing is also the preferred policy in terms of its effect on the economy’s inflation rate. Under the growth-maximizing tax mix, the government relies on both forms of finance but receives most of its revenue from income taxes.

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    File URL: http://www.kansascityfed.org/Publicat/Reswkpap/PDF/rwp00-08.pdf
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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 00-08.

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    Date of creation: 2000
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    Handle: RePEc:fip:fedkrw:rwp00-08

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    Keywords: Income tax ; Currency substitution;

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    1. Marco A. Espinosa & Chong K. Yip, 1995. "Fiscal and monetary policy interactions in an endogenous growth model with financial intermediaries," Working Paper 95-10, Federal Reserve Bank of Atlanta.
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    15. Cavalcanti Ferreira, Pedro, 1999. "Inflationary financing of public investment and economic growth," Journal of Economic Dynamics and Control, Elsevier, vol. 23(4), pages 539-563, February.
    16. Osang, Thomas & Turnovsky, Stephen J., 2000. "Differential tariffs, growth, and welfare in a small open economy," Journal of Development Economics, Elsevier, vol. 62(2), pages 315-342, August.
    17. Alberto Giovannini & Bart Turtelboom, 1992. "Currency Substitution," NBER Working Papers 4232, National Bureau of Economic Research, Inc.
    18. van der Ploeg, Frederick & Alogoskoufis, George S, 1994. "Money and Endogenous Growth," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(4), pages 771-91, November.
    19. Michael Dotsey & Pierre-Daniel Sarte, 1997. "Inflation uncertainty and growth in a simple monetary model," Working Paper 97-05, Federal Reserve Bank of Richmond.
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