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 run. 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 the chapters that follow. The answer we will give to why the central bank might behave in that way is that credit expansion coupled with monetized exchange rate depreciation – monetary expansion, for short – allows it to finance a portion of the government's fiscal deficit.

But of course, monetary emission is not the only option available to the government for financing fiscal deficits. It can also borrow, both from domestic and foreign private sources. Thus, to understand what drives monetary emission, we will also need to consider what determines how much the government can borrow. To do so, we will analyze the government's intertemporal budget constraint (the constraint that must be satisfied by the government's fiscal choices over time) and develop the important concept of fiscal solvency (the perceived ability of the government to honor its financial commitments), which lies at the heart of all the issues to be discussed in the second part of this book.