Monetary Policy & Public Finance

Question 1

why is issuing a new currency considered a tax?

Answer 1

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

Question 2

what happens to the value of existing money each time the CB creates money?

Answer 2

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

Question 3

what does the combined budget constraint of government and CB state?

Answer 3

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:

1. Tt represents revenues generated by taxes (other than inflation)
2. 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
3. the government can print currency - change in the outstanding stock of non-interest-bearing debt, Ht - Ht-1

Question 4

what are the three sources that may fund the government expenditure?

Answer 4

by the budget constraint in nominal income units we can see government expenditure may be financed through

1. taxes
2. an increase in debt
3. seigniorage

Question 5

what are the two parts of seigniorage?

Answer 5

tax base effect & tax rate effect

Question 6

what is the tax base effect of seigniorage?

Answer 6

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.

Question 7

what is the tax rate effect of seigniorage?

Answer 7

(πt/1+πt)ht-1

can be collected in steady-state

Question 8

which of the two parts, tax base effect or tax rate effect, can be collected in steady-state?

Answer 8

tax rate effect

tax base effect transitory as portfolios unchanging in equilibrium

• ht - ht-1 = 0

Question 9

give the intuition behind seigniorage.

Answer 9

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

Question 10

what is the tax interpretation of seigniorage?

Answer 10

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

Question 11

can CB earn seigniorage in time of liquidity trap?

Answer 11

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

Question 12

why is seigniorage when the economy is below full employment effectively a free lunch?

Answer 12

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

Question 13

what does the seigniorage Laffer curve state with regard to the existence of an optimal rate of money supply growth?

Answer 13

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)

Question 14

what determines the turning point on the seigniorage laffer curve?

Answer 14

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

Question 15

how does the seigniorage laffer curve suggest limitations to ECB’s ability to underwrite sovereign debts in southern Europe? does this hold in reality?

Answer 15

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

Question 16

how does the Laffer curve related to unanticipated inflation?

Answer 16

Laffer relation need not apply to unanticipated inflation

• as money demand is pre-determined, surprise inflation doesn’t induce tax base effect

Question 17

how does the laffer relation depend on anticipated inflation rather than unanticipated inflation?

Answer 17

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

Question 18

what does the short-run laffer curve look like?

Answer 18

positive relationship (straight line)

as inflation goes up, SR curve goes down because ht-1 is a function of inflation expectations

Question 19

what are some factors affecting the use of seigniorage?

Answer 19

fiscal deficits

political stability & efficiency of tax collection

other CB objectives

Question 20

how do fiscal deficits affect the use of seigniorage?

Answer 20

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)

Question 21

which scholars discuss fiscal deficits as a factor affecting the use of seigniorage?

Answer 21

Catao & Terrones, 2005

Sargent & Wallace

Question 22

how does political stability & the efficiency of tax collection affect the use of seigniorage?

Answer 22

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

Question 23

what evidence is there to suggest political stability & the efficiency of the tax system affects the use of seigniorage?

Answer 23

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

Question 24

how do other CB objectives affect the use of seigniorage?

Answer 24

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)

Question 25

which scholar discusses other CB objectives as a factor affecting the use of seigniorage?

Answer 25

Reis, 2013

Question 26

what is hyperinflation?

Answer 26

periods during which inflation is at least 50% per month for an extended period of time

Question 27

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?

Answer 27

any attainable seigniorage target must have two possible equilibria

Question 28

what percentage did Cagan estimate the maximum point of the Laffer curve is at?

Answer 28

Cagan estimated that the maximum point is located between 200-300% per annum

Question 29

does Cagan’s estimation of the maximum point hold in reality?

Answer 29

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

Question 30

what do the extremely high rates of hyperinflation in Hungary and Zimbabwe show in relation to the Laffer curve?

Answer 30

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

Question 31

what is the fiscal dominance hypothesis?

Answer 31

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

Question 32

which scholar discusses fiscal dominance hypothesis?

Answer 32

Walsh, 2010

Question 33

explain the Cagan model & how it leads to hyperinflation.

Answer 33

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

Question 34

what is the key assumption for the Cagan model of hypoerinflation?

Answer 34

assumption of adaptive expectations

Question 35

what two points does the vicious cycle of seigniorage & hyperinflation derives from?

Answer 35

1. the tax base effect which induces the downward sloping section of the Laffer curve
2. 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

Question 36

what determines the severity of hyperinflation?

Answer 36

hyperinflation more severe the larger the responsiveness of money demand to expected inflation

Question 37

what evidence does Taylor present for the Cagan model?

Answer 37

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

Question 38

what are the problems with Taylor’s evidence for the Cagan model?

Answer 38

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

Question 39

how can we evaluate the Cagan model using rational expectations?

Answer 39

consider rational private sector agents, rational inflation expectations with financial frictions, and rational policymakers

Question 40

is it realistic to have private individuals forming expectations adaptively?

Answer 40

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

Question 41

how does including rational private sector agents affect the Cagan model?

Answer 41

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

Question 42

is the private sector having rational expectations sufficient to conclude that they could reach point E?

Answer 42

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

Question 43

is it possible not to end in hyperinflation even with adaptive expectations?

Answer 43

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

Question 44

how does having rational expectations with financial frictions affect the model?

Answer 44

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

Question 45

what is Sargent’s evidence against Cagan model adaptive expectations?

Answer 45

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

Question 46

what does Sargent conclude must be happening in the case of Germany in opposition to the Cagan model answer?

Answer 46

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

Question 47

how does having rational policymakers affect the model?

Answer 47

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

Question 48

how can you counter the idea that having rational policymakers would prevent Cagan model dynamics occurring?

Answer 48

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

Question 49

give some international evidence on the use of seigniorage.

Answer 49

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)