Government expenditure and the dynamics of high inflation

This paper develops a dynamic model of inflation where the money supply is determined by the government's use of newly created money to finance its bu dget deficit. In turn, the government's deficit is influenced by past infla tion rates that reduce the real value of tax receipts. While the money supp ly and the budget deficit are modeled as endogenous, government expenditure is assumed to be exogenously determined by the policymaker. Changes in fis cal policy are allowed by modeling expenditure as an autoregressive process subject to discrete switches in regime. Agents are conjectured to have acc ess to a larger set of information than the researcher. This additional inf ormation is incorporated in the rate of inflation through the agents' money demand decision. The econometrician constructs probability assessments con cerning the regime of the spending process at every point in time and refin e his/her inferences by exploiting the structural relationship between infl ation, money growth, and government expenditure. (C) 1999 Elsevier Science B.V. All rights reserved. JEL classification: E31; E63; E65.