Sustainable Growth, the Budget Deficit, and Inflation

This paper analyses the dynamics of economic growth when the government deficit is money financed. Our model specifies capital formation as resulting from internally generated non-traded investment expenditure. The central innovation of this paper is the specification of the long run equilibrium conditions as those of zero acceleration of inflation and capital formation. This gives rise to positive inflation and sustainable growth (positive capital formation). We found there exists multiple economic growth equilibria. One of these is associated with high growth and low inflation; the other with high inflation and low growth. Furthermore, there is policy hysteresis, which has important implications for the current debates on fiscal policy.