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Government financing, inflation, and the financial sector

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We calculate the effects of an increase in government spending financed with labor income taxes or inflation. We take into account the costs of financial services and the endogenous decisions on the use of financial services. Government spending takes the form of government consumption or government transfers. Agents increase the use of financial services to avoid losses from inflation. The financial sector increases with inflation, in accordance with the data. In standard cash-in-advance models, in the presence of government transfers, it is optimal to finance the government with inflation. In our framework, it is optimal to use taxes. We reverse the result from standard cash-in-advance models. The reason is the additional costs from the increase in the financial sector.

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Correspondence to André C. Silva.

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We acknowledge financial support from ADEMU. Silva thanks the hospitality of the Banco de Portugal, where he wrote part of this paper, and acknowledges financial support from Banco de Portugal and Nova SBE Research Unit. The views in this paper are those of the authors and do not necessarily reflect the views of the Banco de Portugal. This work was funded by Fundação para a Ciência e a Tecnologia (PTDC/IIM-ECO/4825/2012, UID/ECO/00124/2019, UIDB/00124/2020 and Social Sciences DataLab, PINFRA/22209/2016), POR Lisboa and POR Norte (Social Sciences DataLab, PINFRA/22209/2016).

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Adão, B., Silva, A.C. Government financing, inflation, and the financial sector. Econ Theory 71, 1357–1396 (2021).

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