Many researchers have found that government deficits produce hyperinflation regardless of the structure of public finance. The Ricardian equivalence theorem states that the method of financing deficits does not influence the determination of equilibrium growth; while monetary growth models indicate that bond-financing of deficits is inflationary when they are measured net of interest. Under uncertainty, risk-neutral preferences imply that Ricardian neutrality holds only if government bonds are fully tax-backed; while monetary growth models modified to account for productivity shocks indicate that the quantitative importance of uncertainty's real effects may be negligible, while its Tobin- Mundell effect may be either standard or reversed, depending on the elasticity of money demand with respect to the interest rate.

In Discussion Paper No. 529, Research Fellow Seppo Honkapohja and Urho Lempinen derive a dynamic model of an economy in which a representative consumer-investor chooses a portfolio of real capital and government bonds. Money demand is based on the cash- in-advance constraint, uncertainty is due to productivity shocks, and the money supply is increased only to finance government deficits, while the government also issues bonds to maintain the initial bonds/money ratio. In the resulting equilibrium with steady growth, consumption is proportional to wealth and the portfolio is constant over time; so government purchases, the bonds/money ratio and the propensity to consume together determine the economy's growth rate. Policy effects on real variables therefore operate through these channels, and nominal variables including asset prices adjust to support the equilibrium.

Honkapohja and Lempinen use their model, in which permanent changes in government expenditures and the bonds/money ratio have both real and nominal effects, to analyse the influence of the precautionary savings motive on the steady-growth effects of government policies in a cash-in-advance economy. Ricardian neutrality is violated, superneutrality only applies to money supply changes that result from tax changes, and the Tobin- Mundell effects induced by expenditure changes or open market operations are reversed if the primary budget is in deficit. Honkapohja and Lempinen find that permanent inflation and reduced growth may therefore occur simultaneously, and they present numerical calculations which indicate that such growth effects may be substantial. They conclude that precautionary effects typically weaken the real and strengthen the nominal effects as the degree of risk aversion is increased: indeed in highly risk- averse economies money is almost superneutral.

Precautionary Saving, Government Policy, and Growth in a Stochastic Cash-In-Advance Economy
Seppo Honkapohja and Urho Lempinen

Discussion Paper No. 529, May 1991 (IM)