Despite widespread claims to the contrary, Government spending does not necessarily cause inflation. Whether this will be the case depends on the willingness of the monetary authorities to help finance government spending by printing money.
Inflationary finance, n seignioragemay be an attractive source of income for government officials. Compared to other types of taxes, it is easy to collect and hard to avoid, it can be implemented quickly, and its effects are invisible to most people. Fortunately, the principles of inflationary finance are easy to understand.
To begin with, we must distinguish between two factors that determine the tax revenue generated by a particular tax. The first is the tax rate. Second – tax base– the amount of the object of taxation. While the taxing authority sets the tax rate, those who are taxed ultimately determine the size of the tax base by choosing how much of the taxable asset to own. This choice depends in part on the tax rate.
In the context of inflationary finance, the tax rate is the rate of inflation set by the monetary authority, which chooses the rate at which the money supply grows; The tax base is the amount of real (inflation-adjusted) money that people own. To understand the relationship between the inflationary tax base and the tax rate, we need to understand how the demand for money responds to changes in the rate of inflation.
An important factor in determining the demand for money is the proportion of wealth that people are willing to hold in cash accounts. This proportion depends on the relative attractiveness of owning wealth in the form of cash compared to other assets such as bonds. While bonds bring a clear return, money does not. Instead, money’s income consists of the liquidity services it provides. As returns on other assets, such as bonds, increase, the relative price of these liquidity services, measured as forgone interest income, increases.
Returns on financial assets such as bonds tend to increase with inflation, a phenomenon that economists refer to as Fisher effect. If you expect prices to rise by 2% in a year, you will require an additional 2% return on your investment to make up for the lost purchasing power. Thus, as inflation rises, so do nominal interest rates. A higher nominal interest rate encourages people to hold a larger share of their wealth in interest-bearing financial assets and a correspondingly smaller share of their income in cash. In other words, the amount of liquidity services they purchase decreases as inflation rises.
While the monetary authorities set the tax rate on cash balances by controlling the money supply, the public decides how much cash balances to hold. Since higher inflation raises the relative price of liquidity services, a unit of cash balances ensures (by increasing returns on other assets) that people have fewer cash balances. Therefore, there is an inverse relationship between the tax rate on cash balances, that is, the rate of inflation, and the amount of cash balances people have.
As the monetary authorities increase the rate of inflation, the amount of cash people hold decreases. The additional income generated by higher inflation rates decreases and may even become negative if inflation rates are high enough. In other words, there is a limit to how much income monetary power can generate without causing runaway inflation.
Suppose the government’s budget deficit is so large that it can no longer generate revenue by raising taxes or issuing bonds. In this case, government officials must resort to inflationary financing to cover the deficit. As a result, inflation will increase as the monetary authorities print the money needed to finance the state budget deficit. As long as the deficit is less than the maximum amount of seigniorage that can be collected given the public’s demand for money, the government’s reliance on inflationary financing will not lead to runaway inflation.
However, in extreme cases, the government budget deficit can be so large that it exceeds the maximum seigniorage obtained from inflationary financing. In this case, inflation will rise without limits, since the monetary authorities will have no choice but to print money at an accelerated rate, which – in the absence of fiscal reforms – will lead to hyperinflation. Unsustainable fiscal trajectories are often the root cause of runaway inflation.
Fortunately, such cases are rare. In most developed countries, seigniorage accounts for a small percentage of total tax revenue. Such countries typically rely on broad-based taxes (sales taxes, income taxes, property taxes, etc.) rather than inflationary financing. The reason they do this is simple. While all taxes are associated with expenses, costs associated with inflationary financing are growing faster than those associated with other forms of taxation.. The less money people have, the fewer transactions, which reduces the profit from trading. The use of more traditional forms of taxation usually reduces the overall damage caused by taxes.
However, as long as central banks are willing to help governments pay their bills, even countries with relatively efficient tax systems will rely to some extent on inflationary financing. Indeed, providing revenue to the government is one of the reasons (and perhaps the main reason) that governments around the world monopolize the issuance of powerful money.