Debt, Cash Flow and Inflation Incentives: A Swedish Example

Can higher inflation dimitish the government debt and contribute to fiancing the budget deficit? And how do these public fiance concerns influence tiationary expectations? These have &n classic qu=tions in mwroeconoti since the seminal papers by Auernheimer (1974), Calvo (1978) and Barro (1983). The same questions recently hme very relevant for several European countries in the aftermath of the 1992-93 ERM crisis. In Sweden, our own country, the government deficit in 1994 stood at about 1370 of GDP. 1 Increasing long bond rates and a depreciating krona -aa well aa higher volatility in hancial markets-were often explained by a fear that "politicians wotid lose control of government tiancea and ~rt to higher inflation as a solution." Developments in other muntries with high debts and deficits, such as Italy or Spain, were similar.