The effects of government financing decisions have been examined from many different viewpoints in the recent literature. These have included the comparison of taxes with bonds, `irrelevance theorems' within overlapping generations models, the relationship between the structure of government deficit finance and inflation and the implications of government fiscal and financing decisions in the long run.
In Discussion Paper No. 397, Research Fellow Seppo Honkapohja and Urho Lempinen consider the effects of government spending, taxation and other financing instruments in an explicitly stochastic framework. They use a stochastic monetary growth model, with a government budget constraint, in which the only source of uncertainty is exogenous productivity shocks. They assume logarithmic preferences and flexible prices and adopt the cash-in-advance constraint as the basis for money demand. They model the consumption-investment decision explicitly using the techniques of dynamic portfolio theory, where consumers hold assets in the forms of real capital and government bonds.
They analyse the effects on the key variables of the economy of changes in both the financing structure and the fundamental levels of government deficits. They also study the effects of supply-side uncertainty on the equilibrium of the economy and the responses of key variables to various policy changes. Finally, they use their model to assess the feasibility of different policies.
Honkapohja and Lempinen find that if the government budget is fundamentally in deficit, then supply-side uncertainty reduces both the nominal interest rate and the mean inflation rate, which modifies the usual inflationary consequences of such a deficit.
Honkapohja and Lempinen also briefly examine the long-run feasibility constraints on the financing of fundamental deficits, and they find that feasible equilibrium policies include various combinations of income taxes, inflation taxes and bond issues as means of financing government deficits.

Supply-Side Uncertainty and Effects of Government Financing Decisions
Seppo Honkapohja and Urho Lempinen

Discussion Paper No. 397, April 1990 (IM)