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Fiscal Crisis Resolution: Taxation Versus Inflation

  • Michael Kumhof

The paper presents a model of fiscal and monetary policy that evaluates the tradeoff between higher distortionary labor taxation and higher inflation in the resolution of fiscal crises. In the model government debt is domestically held and nominal. Data are presented to show that such debt is now at least as important as external government debt in many key emerging markets, and that it is a very important item on the balance sheets of domestic financial intermediaries, despite the disappearance of financial repression. In the model government debt correspondingly enters the economy's intermediation technology. The key contribution of this mechanism is that it makes unanticipated inflation costly. This permits a generalization of existing fiscal theories of the price level by making price level determination the outcome of an explicit government optimization problem over a tax distortion and an inflation distortion. Higher taxes have a distortionary effect on labor supply but a beneficial effect by lowering inflation and supporting a higher public debt stock that in turn supports intermediation and the capital stock. In such a model first period price level jumps generally do not contribute to the resolution of fiscal crises. Instead ongoing but modest inflation is used to levy seigniorage on debt. This gives rise to a fiscal theory of inflation whose transmission mechanism does not rely on base money seigniorage. It is found that a large contribution of inflation to the resolution of a fiscal crisis is only optimal when the fiscal shock is transitory, while a long-lived shock is optimally financed mostly through taxes.

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Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 874.

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Date of creation: 2004
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Handle: RePEc:red:sed004:874
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