Fiscal Policies, Inflation and Capital Formation

Abstract

This paper studies the long-run impact of fiscal policies on inflation and capital formation.The analysis uses an expanded monetary growth model in which the government finances its deficit by issueing both money and interest-bearing debt.One major focus of the paper is the effect of a permanent increase in the government's rea~defic~t in a fully employed economy.The analysis shows that a greater deficit must increase inflation, reduce capital formation, or both.With U.S. tax rules and the prevailing monetary and debtmanagement policies, a greater deficit is likely to cause both more inflation and lower capital intensity.The second purpose of the paper is to analyze the effect of an exogenous increase in the saving rate and the possibility of "excessive saving" that arises when the yield on capital becomes so low that individuals prefer to hold government bonds rather than the more risky claims to real capital.Under some such conditions, an increase in saving could cause unemployment.The analysis shows that this problem can be avoided however by reducing the tax on capital income (or, in some cases, by an increased deficit that absorbs some but not all of the higher savings rate).In short, by using fiscal incentives as well as monetary accomodation, an increased saving rate can be converted to greater capital intensity.

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