Budget Deficits, Stability, and the Monetary Dynamics of Hyperinflation

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Hyperinflationary processes usually occur in countries with extremely large budget deficits. In models of inflationary finance with rational expectations (e.g., Buiter [1987]), large budget deficits cannot lead to hyperinflation. The purpose of this paper is to reconcile the standard theoretical model with the stylized facts. It shows that by introducing a lag in the adjustment of the money market into the standard inflationary finance model, large budget deficits are indeed the main reason for hyperinflation. The paper also provides an explanation for the ineffectiveness of moderate reductions in the deficit in reducing inflation and argues that fiscal lags can be destabilizing. Copyright 1989 by Ohio State University Press.