Government Financing in an Endogenous Growth Model with Financial Market Restrictions

Marco A. Espinosa-Vega and Chong K. Yip
Working Paper 2000-17
October 2000

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In this paper we develop an endogenous growth model with market regulations on explicitly modeled financial intermediaries to examine the effects of alternative government financing schemes on growth, inflation, and welfare.

We find that in the presence of binding legal reserve requirements, a marginal increase in government spending need not result in a reduction in the rate of economic growth if it is financed with an increase in the seigniorage tax rate. Raising the seigniorage tax base by means of an increase in the reserve requirement retards growth and has an ambiguous effect on inflation. An increase in income tax—financed government spending also suppresses growth and raises inflation although not to the extent that the required seigniorage tax rate alternative would. Switching from seigniorage to income taxation as a source of government finance is growth-reducing but deflationary. From a welfare perspective, the least distortionary way of financing an increase in the government spending requirements is by means of a marginal increase in the seigniorage tax rate. Finally, under the specification of logarithmic preferences, the optimal tax structure is indeterminate.

JEL classification: E62, E44, O42

Key words: government financing, endogenous growth, financial intermediaries

The authors thank Bruce Smith; an anonymous referee; participants in the 1999 Taipei International Conference on Economic Growth held at Academia Sinica, Taipei, Taiwan; and the workshop on “Endogenous Growth in Asia: Theory and Evidence” organized by the Center for Studies in Complex Economic Systems, Institute of Economic Research, Kyoto University, Japan, for very helpful comments and suggestions on earlier drafts of the paper. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Marco A. Espinosa-Vega, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713, 404-498-8630,, or Chong K. Yip, Department of Economics, The Chinese University of Hong Kong, Shatin, N.T., Hong Kong, 852-26097057,