Government Expenditure Financing in the Money-in-the-Production-Function Model

Abstract

In this study, we consider a scenario in which the government resorts to an income and inflation tax to finance its expenditures in the money-in-the-production-function model. We show that a financing shift from the inflation tax to the income tax increases the real money holdings-to-capital ratio because the accumulation of capital is less favorable than holding money. We also find that a country’s economic growth rate is maximized if all government expenditures are financed through an income tax. For welfare maximization, the government should set the income tax rate higher than the growth maximizing tax rate and reimburse the excess revenue using money contraction.