Dynamic Macroeconomics

Figure 1.14
Evolution of US federal debt as a percentage of GDP (dark shaded areas indicate major wars; light
shaded areas indicate recessions).
Wars require significant rises in government expenditure. Governments,
instead of raising taxes, resort to temporary borrowing and inflationary
finance to minimize the economic and political disadvantages of significant
hikes in taxes. The same happens during recessions. Recessions result in a
temporary fall in tax revenues, because of the reduction in economic activity,
and temporary increases in expenditure on unemployment insurance and
social protection.
Hence, both wars and recessions result in rises in government deficits and
debts and, in the case of wars, they result in increases in revenue from money
creation. We shall examine the relationship between war finance, inflation,
and government debt in various parts of the book (mainly in chapters 12 and
21).
The United States had remained on the gold standard during World War I.
In addition, in 1913, the Federal Reserve System was created and assumed
the role of the central bank of the United States. The money supply increased
less in the United States than in the United Kingdom during World War I, as
the war affected the US economy and federal government expenditure less

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than in the case of Britain. As a result, the need for seigniorage was not as
large in the United States.
Figure 1.15
 depicts UK public debt as a percentage of GDP since 1792.
Significant rises in the ratio of British public debt to GDP are associated
with major wars, such as the Napoleonic Wars (1803–1815) and the two
great wars of the twentieth century. As in the case of the United States, they
are also associated with recessions, such as the Great Depression of the
early 1930s and the Great Recession of 2008–2009.