Public debt with valued fiat currency in a model of economic growth

Abstract

The paper incorporates Tobin's portfolio balance theory into an overlapping generations model of growth with endogenously valued money in which fiscal policy and/or monetary policy can change the steady state level of the capital stock. The optimal inflation rate that maximizes the steady-state capital stock is a function of the nominal interest rate and the income tax rate. For example, when the nominal interest rate equals 6%, government balances its budget and sets the average income tax rate to be 20%, then the optimal inflation rate for the model economy is about 3.39%. The model can be used to demonstrate how open market intervention could hinder economic growth when the targeted inflation rate is not equal to the optimal inflation rate. In the model, money is neutral but not super neutral. In contrast, with most models that explain real effects of inflation, anticipated changes in the inflation rate have a real effect in this model. This occurs because money and nominal government debt enter the economy not as a helicopter drop but as seigniorage and the Ricardian Equivalence does not hold.