Monetary Policy & Public Finance Flashcards
why is issuing a new currency considered a tax?
each time a CB creates money, the value of existing money is diluted - there is a transfer from existing holders of money balances to recipients of fresh money balances
issuing new currency, rather than collecting taxes paid with existing money, is considered a tax on holders of existing currency
what happens to the value of existing money each time the CB creates money?
value of existing money is diluted - there is a transfer from existing holders of money balances to recipients of fresh money balances
issuing new currency is considered a tax on holders of existing currency
what does the combined budget constraint of government and CB state?
Value of government purchases Gt plus its payment of interest on outstanding privately held debt it-1Bt-1, must be funded by revenue that can be obtained from one of three alternative sources:
- Tt represents revenues generated by taxes (other than inflation)
- the government can obtain funds by borrowing from the private sector - equal to the change in the debt held by the private sector, Bt - Bt-1
- the government can print currency - change in the outstanding stock of non-interest-bearing debt, Ht - Ht-1
what are the three sources that may fund the government expenditure?
by the budget constraint in nominal income units we can see government expenditure may be financed through
- taxes
- an increase in debt
- seigniorage
what are the two parts of seigniorage?
tax base effect & tax rate effect
what is the tax base effect of seigniorage?
first element of seigniorage, ht - ht-1 , occurs when private portfolios adjust in favour of non-interest bearing government liabilities, e.g. when financial sector volatility leads to a preference for liquidity
such revenue sources likely transitory as portfolios unchanging in equilibrium
- ht - ht-1 = 0 in eq.
what is the tax rate effect of seigniorage?
(πt/1+πt)ht-1
can be collected in steady-state
which of the two parts, tax base effect or tax rate effect, can be collected in steady-state?
tax rate effect
tax base effect transitory as portfolios unchanging in equilibrium
- ht - ht-1 = 0
give the intuition behind seigniorage.
high-powered money is not interest bearing => not inflation-proof
even when h is constant, revenue is accrued because the real value of each unit of privately held cash is diminished & the lost resources are transferred to the government
what is the tax interpretation of seigniorage?
ht-1 is the tax base, πt/1+πt is the tax rate
(i) one-off ↑ h ⇒ ↑ revenue stream because tax base expanded
(ii) ↑πt ⇒ ↑revenue stream because real value of public cash holdings redistributed to CB more quickly
even when t = 0 the net worth of the government can be improved via the seigniorage channel, because a change in the composition of government debt towards non-interest bearing liabilities ⇒ reductions in future debt service costs
can CB earn seigniorage in time of liquidity trap?
in a deep recession with interest rates close to zero, the ability of CB to earn seigniorage by increasing the money supply is higher than usual because in deep recession a CB can print money without causing inflation
if the economy is below full employment, seigniorage financing of fiscal deficits is effectively a free lunch ‘no opportunity cost’ - at least while the economy remains with low inflation
why is seigniorage when the economy is below full employment effectively a free lunch?
in a deep recession with interest rates close to zero, the ability of CB to earn seigniorage by increasing the money supply is higher than usual because in deep recession a CB can print money without causing inflation
no opportunity cost
what does the seigniorage Laffer curve state with regard to the existence of an optimal rate of money supply growth?
seigniorage Laffer Curve states that there is an optimal rate of money supply growth
- increasing money supply enables more seigniorage
- increasing money supply causes inflation which decreases demand for money
the seigniorage tax base is endogenous to anticipated inflation
- ↑π ⇒ ↑i (opportunity cost of holding cash) ⇒ ↓ real money demand, i.e. ↓h ⇒ lower tax base next period (in equilibrium)
what determines the turning point on the seigniorage laffer curve?
turning point is where tax base effect starts to dominate tax rate effect
tax rate effect dominates on upward, tax base effect dominates on decline
how does the seigniorage laffer curve suggest limitations to ECB’s ability to underwrite sovereign debts in southern Europe? does this hold in reality?
the max amount of debt it could purchase is the present discounted value from extracting seigniorage revenues at the peak of the Laffer curve in each period
seigniorage represents the largest source of a CB’s net worth, even though it does not appear on a conventional balance sheet
true limit on seigniorage is the future amount of money that will be held willingly by the population as the economy grows, assuming the inflation target of 2% is achieved & interest rates are normal
ECB has more than enough “capital” to support the peripheral bond markets, without this being inflationary in the long run
how does the Laffer curve related to unanticipated inflation?
Laffer relation need not apply to unanticipated inflation
- as money demand is pre-determined, surprise inflation doesn’t induce tax base effect
how does the laffer relation depend on anticipated inflation rather than unanticipated inflation?
tax base, ht-1 , depends on anticipated inflation ⇒ pre-determined from perspective of government seeking to raise revenue in period t
Laffer relation need not apply to unanticipated inflation
- as money demand is pre-determined, surprise inflation doesn’t induce a tax base effect
result: seigniorage revenues monotonically increasing in unanticipated inflation
- e.g. in wartime because as if there is no tax base
what does the short-run laffer curve look like?
positive relationship (straight line)
as inflation goes up, SR curve goes down because ht-1 is a function of inflation expectations
what are some factors affecting the use of seigniorage?
fiscal deficits
political stability & efficiency of tax collection
other CB objectives
how do fiscal deficits affect the use of seigniorage?
governments running persistent deficits must finance them with money creation, producing inflation (Catao & Terrones, 2005)
- fiscal deficits are inflationary in most countries, especially developing economies
- on the other hand, fiscal deficits have no significant positive effect on long-run inflation among developed countries with a long history of low single-digit inflation
governments running persistent deficits have sooner or later to finance those deficits with money creation (‘‘seigniorage’’), thus producing inflation. Persistent deficits cause inflation in the long run but not necessarily in the short run (Sargent & Wallace)
relationship more complex than originally thought & is affected by a variety of factors e.g. efficiency of tax collection, political stability & access to external borrowing (Catao & Terrones, 2005)
which scholars discuss fiscal deficits as a factor affecting the use of seigniorage?
Catao & Terrones, 2005
Sargent & Wallace
how does political stability & the efficiency of tax collection affect the use of seigniorage?
countries with unstable & polarised political systems tend to have more inefficient tax structures & rely more heavily on seigniorage (Cukierman et al., 1992)
Evidence: they test this prediction on cross-sectional data for 79 countries & find a positive association between political instability & seigniorage, even after controlling for other variables
- efficiency of the tax system reflects deliberate political decisions
- the lower the probability that the current government will remain in office & the greater the polarisation, the more inefficient is the tax system lem as a legacy to future governments
seigniorage is a relatively inexpensive source of government revenue if there is widespread tax evasion or if there are large tax-collection cost (Cukierman et al., 1992)
high seigniorage, low CBI, & high regime instability are likely to appear together (Cukierman et al., 1992)
Aisen & Vega (2006) examine the relationship between political instability & inflation rates across 100 countries from 1960-1999
- find that political instability is associated with higher inflation rates
what evidence is there to suggest political stability & the efficiency of the tax system affects the use of seigniorage?
Cukierman et al., 1992
- countries with unstable & polarised political systems tend to have more inefficient tax structures & rely more heavily on seigniorage
- test this prediction on cross-sectional data for 79 countries & find a positive association between political instability & seigniorage, even after controlling for other variables
Aisen & Vega, 2006
- examine the relationship between political instability & inflation rates across 100 countries from 1960-1999
- find that political instability is associated with higher inflation rates
how do other CB objectives affect the use of seigniorage?
unlimited use of & reliance on seigniorage doesn’t account for CBs having to balance the objectives of price stability, economic growth etc
CB’s ability to generate seigniorage revenues is limited by & depends on tolerating higher inflation (Reis, 2013)
CB’s ability to fund an increase in dividends is limited by the size of its market liabilities (Reis, 2013)
which scholar discusses other CB objectives as a factor affecting the use of seigniorage?
Reis, 2013
what is hyperinflation?
periods during which inflation is at least 50% per month for an extended period of time
assuming Cagan model diagram holds & that the fiscal requirement is less than the maximum seigniorage available, how many equilibria must any attainable seigniorage target have?
any attainable seigniorage target must have two possible equilibria
what percentage did Cagan estimate the maximum point of the Laffer curve is at?
Cagan estimated that the maximum point is located between 200-300% per annum
does Cagan’s estimation of the maximum point hold in reality?
200-300% that Cagan estimated is well-below the documented rate of hyperinflation experienced in Hungary between 1923-24 which hit up to a 27-fold increase or Zimbabwe’s 737% per annum rate in July 2020
what do the extremely high rates of hyperinflation in Hungary and Zimbabwe show in relation to the Laffer curve?
this kind of hyperinflation cannot be explained by increases in the inflation rate by governments seeking to raise seigniorage revenues while operating to the left of the turning point of the Laffer curve. Instead, it must be the case that the CBs operate beyond the Laffer curve turning point
what is the fiscal dominance hypothesis?
if deficit is initially debt financed there may be an even larger future seigniorage requirement to pay for the interest (fiscal dominance
fiscal dominance refers to a situation where a government’s fiscal policy, particular budgetary decisions & financing needs, exerts significant influence or control over monetary policy (Walsh, 2010)
- in the context of hyperinflation, where the government’s fiscal actions overwhelm CB’s ability to control money supply & inflation
which scholar discusses fiscal dominance hypothesis?
Walsh, 2010
explain the Cagan model & how it leads to hyperinflation.
key assumption to explaining the unstable dynamics in the Cagan model is the assumption of adaptive expectations, that is πte = πt-1
in the short run, CB can obtain the required seigniorage by increasing money growth & inflation
- quantity theory of money (MV = PY)
the fall in the monetary base caused by increased inflation takes place only after a delay, while inflation takes place immediately, meaning the CB is able to generate increases in the money supply in the short run
CB is constrained by the Laffer curve in the long run as expectations are updated which diminishes the tax base & reduces the revenues gained from seigniorage
CB must then increase inflation to meet its seigniorage target in the short run & the cycle causes explosive inflation
- stuck in a vicious cycle of extra inflation raising insufficient revenue so there is further money creation to finance the deficit which increases inflation which causes a larger deficit and so on
what is the key assumption for the Cagan model of hypoerinflation?
assumption of adaptive expectations
what two points does the vicious cycle of seigniorage & hyperinflation derives from?
- the tax base effect which induces the downward sloping section of the Laffer curve
- adaptive expectations ensure that increased revenues are temporarily available through increasing the inflation rate, even though in the long run there is reversion to the Laffer curve
what determines the severity of hyperinflation?
hyperinflation more severe the larger the responsiveness of money demand to expected inflation
what evidence does Taylor present for the Cagan model?
Taylor (1991) studies European hyperinflation experiences in Austria (1921-22), Germany (1920-23), Hungary (1922-24), Poland (1922-23)
estimates the revenue maximising inflation rate for each country & compares it to the actual peak inflation rate
- in Cagan’s account the latter always exceeds the former
for Germany (1920-23) inflation revenues maximised at estimated inflation rate of 19% per month
- actual hyperinflation peaked at 322% per month
- findings consistent with Cagan model
what are the problems with Taylor’s evidence for the Cagan model?
evidence is indirect
- it tests for an outcome that could be consistent with many models instead of addressing the Cagan mechanism directly
Nielsen (2004) notes that Taylor doesn’t use data through to the ends of the hyperinflation
- incomplete picture
analysis relies on auxiliary assumptions
- e.g. to compute the revenue maximising inflation rate need to make untested assumptions regarding the functional form of the money demand curve
how can we evaluate the Cagan model using rational expectations?
consider rational private sector agents, rational inflation expectations with financial frictions, and rational policymakers
is it realistic to have private individuals forming expectations adaptively?
seems particularly unrealistic that private individuals witnessing hyperinflation would continue to form their expectations adaptively when doing so would cause them to incur large losses
how does including rational private sector agents affect the Cagan model?
without the adaptive expectations assumption, tax base would not be pre-determined
- government could increase seigniorage revenues through decreasing (rather than increasing) π, as tax base would increase with policy announcement, offsetting lower tax rate
- however, constraints on portfolio adjustment may account for a pre-determined tax base even when expectations are rational
with rational expectations (optimising mechanism so don’t make systematic errors) πte = πt + ɛ̝t (error term) could access point E
is the private sector having rational expectations sufficient to conclude that they could reach point E?
might not be possible even with rational expectations
- credibility (if people don’t believe CB’s announcements or their ability to follow through)
- financial frictions (can’t instantaneously change h)
- these frictions means the model might still exist
is it possible not to end in hyperinflation even with adaptive expectations?
even with adaptive expectations, a forward-looking government may choose not to ↑π because this is known to reduce future revenues
need to assume some discounting of the future to rationalise hyperinflation
how does having rational expectations with financial frictions affect the model?
adaptive expectations not crucial to the hyperinflation outcome since rational expectations combined with a portfolio friction could give the same result as it accommodates for pre-determined short-run seigniorage revenues
- stability in the Cagan model requires that expectations not adjust too quickly (Walsh, 2010)
- presence of financial frictions can affect how quickly agents adjust their money holdings in response to changes in inflation expectations
NOTE the friction in question must prevent agents substituting into cash, which is arguably a less realistic requirement than the opposite assumption that agents find it difficult to exit cash for some indexed asset
what is Sargent’s evidence against Cagan model adaptive expectations?
Sargent criticism - causality went in the wrong direction (inflation fell before real money balances)
- found that in the case of hyperinflations ending in Austria, Hungary and Germany, inflation fell before real money balances did
this is inconsistent with the Cagan model based on adaptive expectations as one would expect that money growth would fall first, lowering inflation & then lowering inflation expectations
- this is because in the Cagan model, the only way to boost the tax base & revenues is to lower expected inflation, which means first lowering actual inflation & money growth
in reality, what must be happening is that some institutional / structural reform directly reduces inflation expectations & actual inflation
- e.g. reduction in reparations to be paid by Germany & subsequent growth in money that arose from higher money demand in response to the declining inflation expectations
- e.g. German mark replaced by new currency indexed to price of gold, the circulation of which brought about a fall in inflation
what does Sargent conclude must be happening in the case of Germany in opposition to the Cagan model answer?
in reality, what must be happening is that some institutional / structural reform directly reduces inflation expectations & actual inflation
- e.g. reduction in reparations to be paid by Germany & subsequent growth in money that arose from higher money demand in response to the declining inflation expectations
- e.g. German mark replaced by new currency indexed to price of gold, the circulation of which brought about a fall in inflation
how does having rational policymakers affect the model?
rational policymakers faced with an increased fiscal deficit should foresee that printing money will ultimately prove futile in that it will debase the currency and leave seigniorage revenues below where they started
how can you counter the idea that having rational policymakers would prevent Cagan model dynamics occurring?
monetary policy faces some sort of national emergency & policymakers have no option to pursue seigniorage in the short-run despite long-run cost
alternatively, policymaker discounting may rationalise the decision to increase money growth
policymakers who foresee hyperinflation may choose to print money nonetheless because attempts to boost revenues through promising lower inflation (& so securing an expanded tax base) are doomed to fail if the private sector doubts the credibility of the policymaker & does not adjust expectations & the tax base in response to the announcement
give some international evidence on the use of seigniorage.
Belgium, Denmark, the Netherlands, Spain & the UK, have no identifiable consistent seigniorage policy (Vittorio, 1988)
However, for France, Ireland, Italy, Germany & Greece, seigniorage appears to have been an important component of their financing policies (Vittorio, 1988)
