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 gain or loss on net monetary assets is a central and controversial feature of general price-level-adjusted financial statements. Highly levered companies will show large purchasing power gains on their debt during inflationary periods even when the inflation is correctly anticipated. In this paper, a model is developed, based on the Fisher effect for the adjustment of interest rates to expected inflation, to show that much of the apparent purchasing power gain on debt is due not to real purchasing power gains but, rather, to the gain associated with the reduction in the market value of debt because of unanticipated inflation. When changes in the market value of outstanding debt are explicitly recognized, a significant part of the GPLA purchasing power gain on debt can be viewed as an offset to nominal interest expense to arrive at the real interest expense for outstanding debt.