Endogenous Growth and Inflation

A simple model of the simultaneous determination and interaction of inflation and economic growth is constructed by incorporating money into an optimal growth framework with constant returns to capital. Various channels through which increased inflation tends to reduce growth and declining growth tends to amplify inflation are discussed. Special attention is paid to the potential effects of inflation (a) on saving through real interest rates (or uncertainty), (b) on the income velocity of money, and (c) on the government budget deficit through the inflation tax and tax erosion. Numerical analysis of the model indicates that, although a wide variety of outcomes is possible, inflation and growth tend to be negatively correlated for reasonable values and constellations of the structural parameters of the model, and to vary inversely with one another in response to changes in individual parameters. In particular, budget deficits financed by monetary expansion tend to reduce growth in the long run through their interplay with inflation, saving behavior, portfolio choice, and taxes