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Abstract
This paper develops a dynamic model of inflation where the money supply is determined by the government's use of newly created money to finance its budget deficit. In turn, the government's deficit is influenced by past inflation rates that reduce the real value of tax receipts. While the money supply and the budget deficit are modeled as endogenous, government expenditure is assumed to be exogenously determined by the policymaker. Changes in fiscal policy are allowed by modeling expenditure as an autoregressive process subject to discrete switches in regime. Agents are conjectured to have access to a larger set of information than the researcher. This additional information is incorporated in the rate of inflation through the agents' money demand decision. The econometrician constructs probability assessments concerning the regime of the spending process at every point in time and refine his/her inferences by exploiting the structural relationship between inflation, money growth, and government expenditure.
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