Hyperinflation and Stabilisation: Cagan Revisited.

Using a variant of the Cagan (1956) model with rational expectations, this paper shows that expected stabilization can result in a budget deficit in excess of the maximum inflation tax. A cap on the deficit dampens inflation expectations and raises real balances, thus increasing the yield of the inflation tax for any given rate of inflation. This study extends the work of Alan Drazen and Elhanan Helpman (1990) by including a stochastic budgetary process and using option pricing theory. It uses parameter values of the semielasticity of demand for money to provide estimates of the maximum viable real deficit. Copyright 1997 by Royal Economic Society.