In the previous chapter we saw that a central bank policy of continuous credit expansion and exchange rate depreciation would result in ongoing inflation in the medium term under any of the three alternative assumptions that we have made about the economy's degree of financial integration with the rest of the world. The questions that naturally arise in this context are what would lead the central bank to undertake such a policy and what the benefits and costs associated with it might be for the economy as a whole. This chapter will take up the first of these questions, leaving the second for Chapter 7. The answer we will give to why the central bank might behave in the way we described in the last chapter is that credit expansion coupled with monetized exchange rate depreciation – monetary expansion for short – allows the central bank to finance a portion of the government's deficit.

But of course, monetary emission is not the only option available to the government to finance fiscal deficits. As we have seen in the previous chapters, the government can also borrow, both from domestic and foreign private sources. Thus, we will need to consider what determines how much the government can borrow from domestic and foreign creditors. To do so, we will analyze the government's intertemporal budget constraint, and develop the important concept of fiscal solvency, which lies at the heart of all of the issues to be discussed in the second part of this book.