Optimal Financing of the Government's Budget: Taxes, Bonds, or Money?

Abstract

financing of the government's budget. In particular, we consider taxation, bond issuance, and money creation as alternative means of financing. These issues are not new. Some of them were extensively explored in the public finance literature; some of them were explored in the monetary theory literature. What we believe to be new, however, is that our work integrates the relevant elements from both strands of literature into a unified general equilibrium framework. With this approach we are able to jointly determine the optimal combination of tax rates, the rate of inflation, and the interest rate on government bonds. This type of analysis enables us to ask whether the rate of inflation should be positive or negative, and to provide simple conditions on compensated demand elasticities which determine the answer. It also enables us to reconsider Milton Friedman's optimum quantity of money rule in a public finance framework without lump sum taxes, and to show how this rule should be modified. In addition, we provide insight into the desirability of a social security scheme by showing that such a program is undesirable when social security payments are financed

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