114 M.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 governments in the developed market economies mainly rely on issuing govern- ment bonds instead of printing more money to finance their deficits. 5 The relevant question here is: if the Chinese government uses more bonds and lus less money creation to finance its deficit, will this measure necessarily lower the rate of inflation given that inflation is already a severe problem in the conomy? To provide a pertinent answer to the question posed, we follow the methodology adopted by Byrd(1989), Bennett and Dixon(1995; 1996),Brandt and Zhu(1995), to build a macrotheoretic model based on the existing analytical framework in such a way that it sufficiently characterizes the partially reformed structure observed in the Chinese economy. 6 Using the framework, we show that if the Chinese government uses more bonds to finance its deficit, it may generate a stagflationary effect. Specifically, if the initial fraction of government deficit and debt repayment financed by bonds sufficiently small and if the tax rate on labor income is sufficiently low,an increase in the fraction of government budget deficit and debt repayment financed by government bonds will decrease the growth rate of output and increase the inflation rate. As such, our analysis does provide a possible explanation for the flationary phenomenon experienced in China during the 1993-1996 period The rest of the paper is organized as follows. The institutional features of the Chinese economy is summarized in Section 2. In Section 3, the model is specified Section 4 characterizes the agents' optimization problems, the general equilibrium, and the balanced growth path of the model economy. Section 5 provides the major results and intuitions. Some concluding remarks are offered in Section 6. The derivations of our analytical results are in Appendix A 2. The institutional features of the Chinese economy The following are the six characteristics that have been identified by economists who study the Chinese economy Recently, several analytical models of endogenous growth have been constructed to investigate the macroeconomic implications of government deficits, which are shown to be crucially dependent on how the govemment expenditure is financed. Turnovsky(1992)studies the impact of different methods of government expenditure financing in a Ramsey-Cass economy. Ploeg and Alogoskoufis(1994) ompare the effects on growth and inflation of tax-financed, debt-financed, and money-financed increases in govemment consumption by using an overlapping generations model. Palivos and Y (1995)derive different effects on the growth rate of tax-financed and money-financed increases in 9 6 In Sections 2 and 3, we provide detailed description of the institutional features observed in China emment spending in an endogenous growth model and the specification of the model constructed, respecti 'In China, given the ineffective tax collection, the effective tax rate on labor income is rather low. In addition, according to Watanabe(1997), the government bonds issued are only 4.5% of GNP in 1993and57%in1995114 M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) governments in the developed market economies mainly rely on issuing govern￾ment bonds instead of printing more money to finance their deficits. 5 The relevant question here is: if the Chinese government uses more bonds and thus less money creation to finance its deficit, will this measure necessarily lower the rate of inflation given that inflation is already a severe problem in the economy? To provide a pertinent answer to the question posed, we follow the methodology adopted by Byrd 1989 , Bennett and Dixon 1995; 1996 , Brandt Ž. Ž . and Zhu 1995 , to build a macrotheoretic model based on the existing analytical Ž . framework in such a way that it sufficiently characterizes the partially reformed structure observed in the Chinese economy. 6 Using the framework, we show that if the Chinese government uses more bonds to finance its deficit, it may generate a stagflationary effect. Specifically, if the initial fraction of government deficit and debt repayment financed by bonds is sufficiently small and if the tax rate on labor income is sufficiently low, 7 an increase in the fraction of government budget deficit and debt repayment financed by government bonds will decrease the growth rate of output and increase the inflation rate. As such, our analysis does provide a possible explanation for the stagflationary phenomenon experienced in China during the 1993–1996 period. The rest of the paper is organized as follows. The institutional features of the Chinese economy is summarized in Section 2. In Section 3, the model is specified. Section 4 characterizes the agents’ optimization problems, the general equilibrium, and the balanced growth path of the model economy. Section 5 provides the major results and intuitions. Some concluding remarks are offered in Section 6. The derivations of our analytical results are in Appendix A. 2. The institutional features of the Chinese economy The following are the six characteristics that have been identified by economists who study the Chinese economy. 5 Recently, several analytical models of endogenous growth have been constructed to investigate the macroeconomic implications of government deficits, which are shown to be crucially dependent on how the government expenditure is financed. Turnovsky 1992 studies the impact of different methods Ž . of government expenditure financing in a Ramsey–Cass economy. Ploeg and Alogoskoufis 1994 Ž . compare the effects on growth and inflation of tax-financed, debt-financed, and money-financed increases in government consumption by using an overlapping generations model. Palivos and Yip Ž . 1995 derive different effects on the growth rate of tax-financed and money-financed increases in government spending in an endogenous growth model. 6 In Sections 2 and 3, we provide detailed description of the institutional features observed in China and the specification of the model constructed, respectively. 7 In China, given the ineffective tax collection, the effective tax rate on labor income is rather low. In addition, according to Watanabe 1997 , the government bonds issued are only 4.5% of GNP in Ž . 1993 and 5.7% in 1995