In some of the republics of the former Soviet Union, the expectation following independence was that fiscal policy would be stabilized. In practice, deficits financed by printing money tended to be large and variable. In Discussion Paper No. 1513, Marcus Miller and Lei Zhang adapt Cagan’s analysis of hyperinflation to assess the impact of various fiscal stabilization policies on inflation expectations and real balances.

Miller and Zhang develop a formal model of money- financed deficits and then look at the effect on money holdings of a policy of ‘capping’ the deficit – which involves setting a ceiling so that fiscal reductions are implemented only when the deficit threatens to exceed the ceiling and are thus the minimum necessary to achieve this objective. The authors analyse what happens when there are credible trigger points for budget ‘cuts’, i.e. the effects on inflation and money holdings of anticipated fiscal adjustments designed to reduce the deficit to a target level, as soon as it reaches a pre-announced trigger point. They find that pre-announced budget cuts have a bigger impact than simple ceilings, and conclude by stating that governments may be tempted to announce stabilizations for their beneficial effects on expectations, even when they have no serious intention of carrying them out.

Hyperinflation and Stabilization: Cagan Revisited
Marcus H Miller and Lei Zhang