Economists have long been concerned about the best way to finance government deficits. Finding the proper fiscal policy and monetary policy mix is a crucial decision. When government debt grows too fast, interest rates rise and capital is crowded out. If the money growth rate is excessive, inflation occurs.

The study of this issue at the theoretical level requires a model which incorporates the following features: (1) modeling money and bonds as endogenous financial assets, whose rates of return are determined in general equilibrium, (2) examination of the utility maxi mization decisions of individuals, so that welfare analysis of alternative policies may be made, (3) modeling the government's optimization problem and its budget constraint, and (4) modeling capital investment, showing how the returns to financial assets affect investment decisions. In such a model, the government's financing decisions affect the rates of return on money and bonds, which affect the welfare of individuals. Standard models in the economic literature do not satisfy all these features. The purpose of this paper is to derive such a model.

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Copyright © 1987 Southern Economic Association (SEA). This article first appeared in Southern Economic Journal 54, no. 2 (October 1987): 435-48.

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