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Fiscal Policy and Capital-Flow Reversals
Kim Heng TAN
Division of Economics
Nanyang Technological University
March 2011
Paper prepared for SER Conference 2011
1. Introduction
Brief Literature Review
• It is well known that an increase in government spending
financed by taxes in an open economy will worsen its
current account and induce capital inflows.
• If government spending is financed by money seigniorage,
public saving remains unaffected while private saving
changes in ways that are not clear-cut.
– Using the Solow (1956) - Swan (1956) neoclassical
growth model, Tobin (1965) shows that increasing the
rate of monetary growth raises savings in the long run.
– Using the Ramsey (1928) model, in which utilitymaximizing economic agents live infinite lives,
Sidrauski (1967) shows that money is superneutral.
• If government spending is financed by money seigniorage,
public saving is unaffected while private saving changes in
ways that are not clear-cut (continued).
– Stockman (1981) shows that, if investment purchases
are subject to a cash-in-advance constraint, increasing
the rate of monetary growth reduces saving in capital
goods in the long run.
– Orphanides & Solow (1990) survey the literature on the
long-run effects of monetary growth on saving and
capital formation.
• Although the LR effects of government spending financed
by money seigniorage on the current/capital accounts can
be deduced from the monetary-growth literature,
– the findings are incomplete for two reasons.
• 1st, it is usually assumed that
– government spending has no effect on the intertemporal
allocation of private consumption,
• i.e., private consumption is independent of
government spending.
• If government spending affects the intertemporal allocation
of private consumption, then an increase in government
spending will affect private saving,
– depending on the degree of substitutability or
complementarity between private and public
consumption.
• 2nd, the government budget constraint is usually considered
without regard to the initial inflation rate prevailing in the
economy.
• When initial inflation rates are relatively low,
– increasing money seigniorage to finance government
spending entails increasing monetary growth and
inflation.
• When initial inflation rates are high,
– increasing money seigniorage to finance government
spending entails decreasing monetary growth and
inflation.
• This difference in changing monetary growth/inflation to
finance government spending affects savings and the
current/capital accounts differently,
– depending on the initial inflation rate.
Objective
• To take into account the deficiencies in the literature
– in investigating the effects of increasing government
spending financed by money seigniorage on the current
account and capital flows.
Motivation
• Since the Asian Financial Crisis, issues related to the
current account and capital flows have become more
important.
• Since fiscal policy is a key macroeconomic policy option,
it is natural to investigate the effects of fiscal policy on the
current account and capital flows.
• The findings here have policy relevance for economies
attempting to inflate their way to pay for government
spending.
Contribution
• This paper will show what are not so well known:
– The long-run effects of fiscal policy on the current
account and capital flows depend on
• the initial inflation rate and
• the degree of substitutability between public and
private consumption.
– As the economy goes from low to high inflation, capital
flows can reverse, creating another source of macroinstability.
2. Model
• The model used is an open-economy version of
Samuelson’s (1958) overlapping-generations model in
which
– consumers maximize utility subject to their budget
constraints,
– producers maximize profits, and
– the government finances its spending by means of
money seigniorage and (lump-sum) taxes.
• Money seigniorage is
– real revenue available from money creation;
– dependent on the inflation rate, as shown in the moneyseigniorage Laffer curve in Figure 1:
• increasing with inflation when inflation is below the
seigniorage-maximizing rate of p*, but
• decreasing with increasing inflation when inflation
is above p*.
Figure 1: Money-Seigniorage Laffer Curve
p*
• Government spending financed by money seigniorage
affects savings through two effects:
– the intertemporal allocation effect of government
spending on saving and
– the inflation effect of money seigniorage on saving.
• Consider the intertemporal allocation effect.
– An increase in government spending increases
(decreases) private consumption and decreases
(increases) saving
• if consumption is complementary (substitutable)
with government spending.
• Consider the inflation effect.
– As government spending is increased, money
seigniorage has to be increased.
– However, increasing money seigniorage is dependent
on where the economy is on the money-seigniorage
Laffer curve.
– On the upward-sloping (downward) portion of the
curve, increasing money seigniorage entails increasing
(decreasing) money growth/inflation.
– The increase or decrease in inflation in turn affects
savings.
• The interaction of the two effects
– causes an increase in government spending to affect
savings, the current account and capital flows,
depending on
• the degree of substitutability between public and
private consumption and
• the initial inflation rate prevailing in the economy.
3. Results & Explanation
Result 1
• When public & private consumption are independent, a
permanent increase in government spending
– improves the current account and induces capital
outflows at initial inflation rates below the seignioragemaximizing rate of p*, and
– worsens the current account and induces capital inflows
at inflation rates above p*.
Figure 2 – A Single Inflation Threshold when Public and
Private Consumption are Independent
p*
Explanation of Result 1
• An increase in government spending has to be financed by
an increase in money seigniorage.
• When initial inflation is below the seigniorage-maximizing
rate of p*,
– the economy is on the upward-sloping portion of the
money-seigniorage Laffer curve,
– seigniorage increases with increasing inflation,
– so increasing government spending entails increasing
monetary growth & inflation.
• By reducing the real return to money and reducing real
money holdings,
– an increase in inflation increases savings, improves the
current account and induces capital outflows.
• When initial inflation exceeds the seigniorage-maximizing
rate of p*,
– the economy is on the downward-sloping portion of the
money-seigniorage Laffer curve,
– seigniorage increases with decreasing inflation,
– so increasing government spending entails reducing
inflation;
– reducing inflation reduces savings, worsens the current
account and induces capital inflows.
Result 2
• When public & private consumption are complementary, a
permanent increase in government spending
– worsens the current account and induces capital inflows
at initial inflation rates below a threshold of p1 < p* or
at rates above p*, and
– improves the current account and induces capital
outflows at inflation rates between p1 and p*.
Figure 3 – Two Inflation Thresholds when Public and
Private Consumption are Complementary
p1
p*
Explanation of Result 2
• When public & private consumption are complementary,
an increase in government spending
– increases private consumption and decreases savings.
(intertemporal allocation effect of government spending)
• Recall from the explanation of Result 1 that
– below (above) p*, an increase in government spending
entails increasing (decreasing) monetary growth &
inflation, hence increasing (decreasing) savings.
(inflation effect of government spending)
• The intertemporal allocation effect and the inflation effect
of government spending
– work against each other below p* but
– reinforce one another above p*.
• Above p*, therefore, an increase in government spending
decreases savings, worsens the current account and induces
capital inflows.
• Below p*, the net effect of government spending on
savings depends on which effect dominates.
• At low inflation rates, below a threshold of p1 < p*,
– the inflation effect is weak,
– so increasing government spending decreases savings,
worsens the current account and induces capital
inflows.
• At higher rates, between p1 and p*,
– the inflation effect dominates,
– so increasing government spending increases savings,
improves the current account and induces capital
outflows.
Result 3
• When public & private consumption are substitutable, a
permanent increase in government spending
– improves the current account and induces capital
outflows at initial inflation rates below p* or above a
threshold of p2 > p*, and
– worsens the current account and induces capital inflows
at inflation rates between p* and p2.
Figure 4 – Two Inflation Thresholds when Public and
Private Consumption are Substitutable
p*
p2
• Result 3 can be similarly explained by considering
– the intertemporal allocation effect of government
spending in conjunction with
– the inflation effect of government spending.
Discussion of Results
• When government spending has no intertemporal
allocation effect on private consumption, there exists a
single inflation threshold.
• When government spending has an intertemporal
allocation effect on private consumption, there exist two
inflation thresholds.
• As the economy crosses each inflation threshold from low
to high inflation, the economy experiences a reversal of
capital flows.
• Keynes (1919) wrote, “There is no subtler, no surer means
of overturning the existing basis of society than to debauch
the currency.”
• While the macroeconomic instability of hyperinflation
identified by Keynes is by now well known in the
literature, what is not so well known is that
– the reversal of capital flows due to hyperinflation that is
identified here can present another source of macroinstability via movements in the exchange rate.
4. Conclusion
• The current-account and capital-flow effects of
government spending financed by money seigniorage
depend on
– the degree of substitutability between public and private
consumption and
– where the economy is in relation to certain inflation
thresholds.
• The reversal of capital flows at each inflation threshold is a
source of macro-instability.