Inflationary Deficit Financing in an Open Economy: Evolutionary Dynamics

This paper describes the dynamics of adaptation in a two-country, overlapping generations economy with no restrictions on foreign currency holdings. Governments of both countries finance their deficits via seignorage. Agents in this economy are boundedly rational. They use the genetic algorithm to update their decision rules. Agents' decisions are related to the total amount of savings between two periods of their lives and the fractions of savings held in each currency. The results of imulations show that the currency of the country that finances the larger of the two deficits becomes valueless. The adjustment process is characterized by a flight away from the currency used to finance the larger of the two deficits. The economy converges to a stationary equilibrium that corresponds to a single-currency economy. Agents keep all of their savings in the currency used to finance the lower of the two deficits.