Money-Financed Government Deficits and Bank Fragility in Frontier Economies
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Money-Financed Government Deficits and Bank Fragility in Frontier Economies
Publisher: African Review of Economics and Finance
Pub: 2026-09-29 09:13:16
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Does monetary financing of an unfunded fiscal expansion weaken the balance sheet of banks? We address this question by developing a small open-economy DSGE model that integrates fiscal-monetary interactions, an endogenous country risk premium, and a banking sector. We estimate the model using quarterly Ghanaian data from 2014Q2 to 2024Q2, and then use the estimated structural model to simulate the macroeconomic and banking-sector effects of a seigniorage-financed fiscal expansion.The results reveal a sharp macro-financial trade-off. Although money-financed spending initially raises output and employment, the resulting inflation and currency depreciation erode bank profitability, weaken capital adequacy, and lower the Z-score. As bank balance sheets deteriorate, credit spreads widen and lending contracts, choking off the initial stimulus as weaker financial intermediation reverses the early gains in output and employment and ultimately push real activity into decline. Counterfactual financing experiments show that mixed tax and bond financing substantially improves banking sector outcomes relative to full monetization. The findings imply that, in bank-dominated frontier economies with limited fiscal space, using seigniorage as a stopgap source of fiscal revenue imposes costs beyond price instability. It weakens bank balance sheets, constrains credit intermediation, and creates a persistent drag on real economic activity.
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Keywords
Fiscal dominance, Bank fragility, Bayesian DSGE, Ghana, Frontier economies, Money-financed deficits.
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Keywords
Fiscal dominance, Bank fragility, Bayesian DSGE, Ghana, Frontier economies, Money-financed deficits.