Chapter 1 Monetary and Fiscal Policy1

1.1 Introduction
A public-finance approach yields several insights. Among the most important is the recognition that fiscal
and monetary policies are linked through the government sectors budget constraint. Variations in the
inflation rate can have implications for the fiscal authoritys decisions about expenditures and taxes, and,
conversely, decisions by the fiscal authority can have implications for money growth and inflation.
When inflation is viewed as a distortionary revenue-generating tax, the degree to which it should be relied
upon depends on the set of alternative taxes available to the government and on the reasons individuals
hold money. Whether the most appropriate strategy is to think of money as entering the utility function as
a final good or as serving as an intermediate input into the production of transaction services can have
implications for whether money should be taxed. The optimal-tax perspective also has empirical
implications for inflation.

1.2 Budget Accounting

To obtain goods and services, governments in market economies need to generate revenue. And one way
that they can obtain goods and services is to print money that is then used to purchase resources from the
private sector. However, to understand the revenue implications of inflation (and the inflation
implications of the governments revenue needs), we must start with the governments budget constraint 2.
Consider the following identity for the fiscal branch of a government:
, (1) tTtTttTtttRCBBBTBiG++=+)(111
where all variables are in nominal terms. The left side consists of government expenditures on goods
,services, and transfers , plus interest payments on the outstanding debt (the superscript T denoting total
debt, assumed to be one period in maturity, where debt issued in tGTttBi11
1 This

chapter draws from Walsh (2003, Chpter 4).

(1992) provides a general discussion of government deficits and accounting.

2 Bohn

Lectures on