1. Fiscal Policy and Capital-Flow Reversals
Kim Heng TAN
Division of Economics
Nanyang Technological University
March 2011
Paper prepared for SER Conference 2011

2. Brief Literature Review
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.

3. 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 utility-maximizing economic agents live infinite lives, Sidrauski (1967) shows that money is superneutral.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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 macro-instability.

12. 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.

13. Money seigniorage is
real revenue available from money creation;
dependent on the inflation rate, as shown in the money-seigniorage 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*.

14. Figure 1: Money-Seigniorage Laffer Curvep*

15. 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.

16. 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.

17. 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.

18. 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 seigniorage-maximizing rate of p*, and
worsens the current account and induces capital inflows at inflation rates above p*.

19. Figure 2 – A Single Inflation Threshold when Public and Private Consumption are Independent

20. 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.

21. 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.

22. 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.

23. 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*.

24. Figure 3 – Two Inflation Thresholds when Public and Private Consumption are Complementary
p1 p*

25. 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)

26. 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.

27. 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.

28. 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.

29. Figure 4 – Two Inflation Thresholds when Public and Private Consumption are Substitutable

30. Result 3 can be similarly explained by considering
the intertemporal allocation effect of government spending in conjunction with
the inflation effect of government spending.

31. 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.

32. 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 macro-instability via movements in the exchange rate.

33. 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.