Inflation, Fiscal Deficits, and Multiple Steady States in a Cash-in-Advance Model

Abstract

Using a model where a cash-in-advance constraint is imposed on both consumption and investment and the central bank is compelled to finance a fiscal deficit through money creation, this paper shows that there are two or three steady states. If two steady states exist, a high-inflation trap can appear, and an economy will most probably converge to a high-inflation steady state. If three steady states exist, a poverty trap can occur, and an economy where the initial capital stock is less than a threshold level reaches a high-inflation and low-capital steady state.

Keywords: inflation, fiscal deficit, multiple steady states

JEL Classification: E31, E52, E62