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Inflationary Consequences of Anticipated Macroeconomic Policies

Listed author(s):
  • Allan Drazen
  • Elhanan Helpman

We consider a model in which the level of taxes and seignorage are too low to finance government expenditures and debt service. Government debt will therefore grow without bound, implying the eventual need to change policy. Starting with utility maximization, we analyze the effect of the expected switch on equilibrium time paths before the switch takes place. We analyze stabilization via increasing taxes, increasing money growth rates, or cutting expenditures, both under certainty and under uncertainty about the composition or timing of a stabilization. Under full certainty, inflation may rise, fall, or remain constant before the stabilization, depending on which policy tool is used to stabilize. Uncertainty solely about the composition of the stabilization will yield paths in between the above cases, with a price jump at the time of stabilization. In general there is no simple correlation between changes in the budget deficit and inflation. With uncertainty about the timing OF a stabilization, the inflation rate will most likely exhibit fluctuations and may overshoot its steady state value, even when real balances move monotonically. Uncertainty about the timing of a stabilization can therefore itself induce fluctuation in inflation, even if underlying utility and subjective probability functions are smooth.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2006.

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Date of creation: Aug 1986
Publication status: published as Review of Economic Studies, Vol. 57, No. 189, pp. 147-164, (January 1990).
Handle: RePEc:nbr:nberwo:2006
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  1. Frank Hahn, 1985. "Money and Inflation," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262580624, January.
  2. Liviatan, Nissan, 1984. "Tight money and inflation," Journal of Monetary Economics, Elsevier, vol. 13(1), pages 5-15, January.
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