Hyperinflation and Stabilization: Cagan Revisited

Using a variant of the Cagan 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 Drazen and Helpman (1990) by including a stochastic budgetary process and using option pricing theory. It uses parameter values of the semi-elasticity of demand for money to provide estimates of the maximum viable real deficit.