Asymmetric Information and Alternative Government Financing: A Comparison

Abstract

This paper compares the relative merits of alternative government financing in the presence of asymmetric information. We first establish that the share of government expenditure determines whether or not credit is rationed, which in turn plays an important role in determining the relative merits of monetary and income-tax financing. It is found that monetary financing leads to both higher inflation and economic growth than income-tax financing if credit is not rationed. If credit is rationed, however, monetary financing leads to a higher inflation rate but a lower growth rate than tax financing. In comparing social welfare, we find that monetary (income-tax) financing is better than income-tax (monetary) if credit is not rationed (rationed). Our results reconcile the pre-existing literature and are consistent with some empirical evidence.