In this paper I examine from a theoretical perspective the policy proposal made by Krugman (1998a) for inducing inflation to rejuvenate the Japanese economy. The main findings are that the government's budget constraints imply that (1) in order to realize long-term inflation, it is insufficient to just have the central bank issue currency; an expansionary fiscal policy is also necessary; and (2) the government can credibly commit to future inflation by undertaking expansionary fiscal policy in the current period. I also examine the optimal policy mix of fiscal and monetary policies for an economy that suffers from a huge fiscal deficit and a liquidity trap. In addition, I modify the Krugman model to a three-period model and show that in circumstances in which the nominal interest rate is zero, temporary deflation may be aggravated if fiscal policies remain unchanged and the central bank increases the money supply.
Published: Keiichiro Kobayashi, 2005. "Fiscal Consequences of Inflationary Policies," Journal of the Japanese and International Economies, Vol. 19(3), pp. 386-393.