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Debt Financing

Andre Silva (andre.silva@novasbe.pt) and Bernardino Adao
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Bernardino Adao: Banco de Portugal

No 577, 2012 Meeting Papers from Society for Economic Dynamics

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.

Date: 2012
New Economics Papers: this item is included in nep-dge
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Citations: View citations in EconPapers (5)

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