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

  • Jill A. Holman
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    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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    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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    1. King, R.G. & Rebelo, S., 1988. "Public Policy And Economic Growth: Developing Neoclassical Implications," RCER Working Papers 225, University of Rochester - Center for Economic Research (RCER).
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    6. Rebelo, Sergio, 1991. "Long-Run Policy Analysis and Long-Run Growth," Journal of Political Economy, University of Chicago Press, vol. 99(3), pages 500-521, June.
    7. 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.
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    13. Kim, Se-Jik, 1998. "Growth effect of taxes in an endogenous growth model: to what extent do taxes affect economic growth?," Journal of Economic Dynamics and Control, Elsevier, vol. 23(1), pages 125-158, September.
    14. John H. Boyd & Ross Levine & Bruce D. Smith, 1997. "Inflation and financial market performance," Working Papers 573, Federal Reserve Bank of Minneapolis.
    15. Michael Dotsey & Pierre-Daniel Sarte, 1997. "Inflation uncertainty and growth in a simple monetary model," Working Paper 97-05, Federal Reserve Bank of Richmond.
    16. 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.
    17. Turnovsky, Stephen J, 1997. "Equilibrium Growth in a Small Economy Facing an Imperfect World Capital Market," Review of Development Economics, Wiley Blackwell, vol. 1(1), pages 1-22, February.
    18. Edwards, Sebastian & Tabellini, Guido, 1991. "Explaining fiscal policies and inflation in developing countries," Journal of International Money and Finance, Elsevier, vol. 10(1, Supple), pages S16-S48, March.
    19. Alberto Giovannini & Bart Turtelboom, 1992. "Currency Substitution," NBER Working Papers 4232, National Bureau of Economic Research, Inc.
    20. 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.
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