where A is the current-valued Lagrange multiplier associated with (2.3). Equation (2.6) will play a central role in our derivations so.

The Government

The government purchases goods, g, makes transfer payments, v. levies lump sum taxes, r, and may borrow at the real interest rate r. In addition, the government

According to this condition, the present value of future surpluses including the value of seignorage revenues must equal the value of the government’s net initial debt.

A Competitive Equilibrium

A competitive perfect foresight equilibrium for this economy is a set of allocations ct, mt, bt + dt, a set of prices Pt and St, and a set of paths for the fiscal variables, Tt, gt and vt, such that the following conditions hold: (i) ct, rnt. bt + dt solve the household’s problem given the paths for Pt,St, rt and vt (ii) the government’s intertemporal budget constraint (2.8) holds; and (iii) St = Pt for all t. Note that this definition applies to an economy operating under either a fixed or a flexible exchange rate equilibrium.

In a sustainable fixed exchange rate regime agents anticipate zero inflation and (2.6) reduces to:

So in a sustainable fixed exchange rate regime, the money supply is constant and the present value of current and future real surpluses equals the initial real net liabilities of the government: no seignorage revenues are available to the government . In our model economy, seignorage revenues can be generated only if the country abandons the fixed exchange rate regime.8 In a fixed exchange rate regime, the government’s intertemporal budget constraint (2.8) simplifies to:

Suppose that at time 0 agents learn that there has been an increase, ф, in the present value of the deficit due to a rise in future transfer payments. Specifically, we assume that transfers increase permanently after date T’\

where A is the current-valued Lagrange multiplier associated with (2.3). Equation (2.6) will play a central role in our derivations so. The Government The government purchases goods, g, makes transfer payments, v. levies lump sum taxes, r, and may borrow at the real interest rate r. In addition, the government According to this condition, the present value of future surpluses including the value of seignorage revenues must equal the value of the government’s net initial debt. A Competitive Equilibrium A competitive perfect foresight equilibrium for this economy is a set of allocations ct, mt, bt + dt, a set of prices Pt and St, and a set of paths for the fiscal variables, Tt, gt and vt, such that the