Inflation Financing and banks balance sheet: a fiscalist stagflation

Orientador(a): Tiago Couto Berriel

We develop a New Keynesian model with financial frictions and a maturity mismatch on banks balance sheets. The longer maturity of assets relative to liabilities gives rise to a inflation mismatch, as the former become more sensitive to unanticipated price shocks. Based on the Fiscal Theory of the Price Level, we study the costs of inflation financing in this environment and offer alternative interpretation for crises episodes arising from unsustainable fiscal policy. Contrary to conventional models with fiscal determination and price rigidities, we find that deficits can be stagflationary as inflation deteriorates banks balances, reducing capital finance, investments and output. The fall on capital acts a supply side shock to the economy, rising the cost of capital and inflation, which helps to restore government solvency.