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Debt Financing

Author

Listed:
  • Andre Silva

    (Universidade Nova de Lisboa)

  • Bernardino Adao

    (Banco de Portugal)

Abstract

We show that the predictions about the effects of financing the debt with taxes or inflation change when households react by changing their demand for money. In the model, the households change the optimal interval between bond trades to change the demand for money. In standard cash-in-advance models, the interval between trades is fixed, which implies an inelastic demand for money in the long run. With optimal trading intervals, the demand for money is elastic and has a better fit to the data. We find that consumption decreases in similar magnitudes for fixed or optimal time intervals for an increase of 10% in government purchases financed with taxes. On the other hand, the decrease in consumption is much higher with optimal time intervals when the increase in government purchases is financed with inflation. According to the model, financing the increase in purchases with inflation implies a decrease in consumption of 3.4% with fixed intervals, but a decrease in consumption of 21% with endogenous intervals. Moreover, the predicted welfare losses are much larger when the reaction of households is taken into account.

Suggested Citation

  • Andre Silva & Bernardino Adao, 2012. "Debt Financing," 2012 Meeting Papers 577, Society for Economic Dynamics.
    • Handle: RePEc:red:sed012:577
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    References listed on IDEAS

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    Cited by:

    1. Miller, Stephen M. & Martins, Luis Filipe & Gupta, Rangan, 2019. "A Time-Varying Approach Of The Us Welfare Cost Of Inflation," Macroeconomic Dynamics, Cambridge University Press, vol. 23(2), pages 775-797, March.
    2. Bernardino Adao & Andre C. Silva, 2017. "Sub-optimality of the Friedman rule with distorting taxes," Nova SBE Working Paper Series wp623, Universidade Nova de Lisboa, Nova School of Business and Economics.
    3. Kavita Surana & Anuraag Singh & Ambuj D Sagar, 2020. "Strengthening science, technology, and innovation-based incubators to help achieve Sustainable Development Goals: Lessons from India," Papers 2005.13138, arXiv.org, revised Jun 2020.

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