Government Financial Policy and Capital

Abstract

Economists have long been concerned about the best way to finance government deficits. Finding the proper fiscal policy and monetary policy mix is a crucial decision. When government debt grows too fast, interest rates rise and capital is crowded out. If the money growth rate is excessive, inflation occurs. The study of this issue at the theoretical level requires a model which incorporates the following features: (1) modeling money and bonds as endogenous financial assets, whose rates of return are determined in general equilibrium, (2) examination of the utility maximization decisions of individuals, so that welfare analysis of alternative policies may be made, (3) modeling the government's optimization problem and its budget constraint, and (4) modeling capital investment, showing how the returns to financial assets affect investment decisions. In such a model, the government's financing decisions affect the rates of return on money and bonds, which affect the welfare of individuals. Standard models in the economic literature do not satisfy all these features. The purpose of this paper is to derive such a model. Macroeconomic models often assume that it is optimal to maximize consumption or output of the economy. This paper shows clearly that such an assumption is false in a dynamic context. Output can be maximized by government policy which drives the interest rate to a low level. But the interest rate affects intertemporal consumption possibilities, and a low interest rate may reduce welfare. The goal of this paper is thus to examine the optimal growth rates of money and government debt, considering their implications for welfare. Changes in the rates of return on money and debt affect welfare in three ways: (1) they affect the capital stock and thus output, (2) they affect consumption directly because people take out consumption loans, and (3) they affect the quantity of resources devoted to transactions costs. We develop a model of the financial-asset holding decision. Money and bonds are the two financial assets. Bonds are an explicit contract between two agents in the economy, a contract which is costly to write. Money is issued by the government by fiat, and represents a costless, implicit contract with a zero nominal rate of return.