Government deficits, wealth effects and the price level in an optimizing model

This paper investigates the in inflationary effects of fscal policy in an optimizing general equilibrium monetary model with capital accumulation, exible prices and wealth effects. The model is calibrated to Euro Area quarterly data. Simulation results show that government defcits, high debt level and slow fiscal adjustment adversely affect price stability in the presence of an independent monetary authority adopting a monetary targeting regime. The mechanism through which fiscal policy affects the dynamics of the price level presents monetarist properties, since the price level is determined in the monetary market. The effects produced by fiscal expansions on price dynamics are due to the behavior of consumers, facing a positive probability of death and sharing the burden of fiscal adjustment with future generations. Fiscal variables are shown to influence the consumption plan of individuals and the demand for real money balances, thus affecting the equilibrium conditions in the money market where the price level is determined.