Fiscal and Monetary Policy in a Basic Endogenous Growth Model

We present a monetary endogenous growth model and analyse the effects of fiscal and monetary policy with real money as an argument in the utility function. We show that a balanced government budget gives a higher balanced growth rate and lower inflation than a situation with permanent public deficits. It also leads to higher welfare compared to a situation with permanent deficits when the government does not put a high weight on stabilizing debt. However, when governments run deficits with a high weight on stabilizing debt, comparative welfare effects depend on the initial conditions with respect to public debt. Further, for a given monetary policy a stricter debt policy yields higher growth, lower inflation and higher welfare. A rise in the nominal money supply can compensate the negative growth effects of a loose debt policy up to a certain point but only at the cost of higher inflation and lower welfare.