Supply Side Uncertainty and Effects of Government Financing Decisions

In this paper we develop a stochastic monetary growth model with exogenous productivity shocks to consider the effects of changes in the financing structure of government deficits on the key variables of the economy. We study how the presence of supply-side uncertainty affects the equilibrium of the economy and the responses of key variables to the various policy changes. Finally, we consider the feasibility of different policies in the model. Introducing uncertainty in the model lowers (raises) the nominal interest rate and the mean inflation rate in the economy, if the fundamental government budget is in deficit (surplus). Changes in the bonds-to-money ratio turn out to have both real and nominal effects in the model. A permanent open market sale is a contractionary measure with respect to output and growth but unambiguously raises the equilibrium nominal interest rate and most likely accelerates inflation.