The optimal rate of monetary expansion is derived for the case when the government resorts to deficit financing to finance its development expenditure. It is argued that, while higher rates of monetary expansion increase investment and contribute to future consumption, the consequent inflation imposes welfare costs by reducing the level of real balances held by the public. A theoretical framework is developed and its empirical implications considered by deriving the optimal rate of monetary expansion which maximizes the discounted flow of total consumption--material consumption minus the disutility of holding suboptimal levels of real balances--over time.

The late 1970's and early 1980's proved to be extremely trying economic times for the developing countries. Throughout most of the period, a combination of exogenous shocks, such as worsening terms of trade, falling growth rates in industrial countries, and sharp changes in the cost and availability of foreign financing, created serious macroeconomic management problems for policymakers in these countries. Adjustment to these shocks required fiscal and monetary restraint to control both public and private spending, and the adoption of a flexible exchange rate policy to prevent the emergence of unsustainable current account deficits, growing foreign debt burdens, and steady losses of international competitiveness. With certain exceptions, developing countries generally did not follow this policy prescription, and consequently compounded the negative effects of the exogenous shocks. The purpose of this paper is to evaluate the exchange rate responses of developing countries to the variety of exogenous shocks they faced in recent years. Essentially this involves an analysis of the behavior of the real exchange rate. Exchange rate policy responses have to be judged in terms of how the authorities used combinations of nominal exchange rate action and other policies to restrain domestic prices and factors to either support or offset the movements in the real exchange rate caused by external shocks. In this paper I discuss first the principal external shocks that occurred during the past decade, and then the likely effects of these on the real exchange rate. The picture is completed by a description of how real exchange rates actually evolved in developing countries during the period under consideration.