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Unanticipated Inflation and Government Finance: The Case for an Independent Common Central Bank

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  • van der Ploeg, Frederick

Abstract

This paper discuss the merits of an independent "EuroFed" within the context of a tax/seigniorage smoothing model for a monetary union. There is an incentive to use a surprise inflation tax to wipe out the real value of government debt and wage contracts because this allows a cut in distortionary taxes and boost employment and private consumption. If dependent central banks can pre-commit, there is no case for an independent EuroFed as this leads to a sub-optimal government revenue mix. If only an independent EuroFed can guarantee sufficient discipline, however, a case can be made for it over and above a monetary union with a non-cooperative or cooperative central bank. This case is stronger when the aversion to inflation is high, when the outstanding stock of nominal government debt is high, when the underground economy is insignificant and when there is little indexation. Even if all contracts are indexed, there is an incentive to create unanticipated inflation if money demand depends on expected inflation. If private agents are rational in their forecasts of inflation, however, government spending is financed through temporary bouts of taxation and inflation, and given that all contracts are indexed, no case for an independent central bank can be made. Competition between central banks of a monetary union induces excessive inflation, because each bank fails to internalize the externalities associated with appropriating too much seigniorage from the common central bank.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 562.

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Date of creation: Aug 1991
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Handle: RePEc:cpr:ceprdp:562

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Keywords: Credibility; Eurofed; Inflation; Monetary Union; Policy Coordination; Seigniorage;

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References

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  1. Rogoff, Kenneth, 1985. "Can international monetary policy cooperation be counterproductive?," Journal of International Economics, Elsevier, vol. 18(3-4), pages 199-217, May.
  2. Robert J. Barro, 1983. "Inflationary Finance under Discretion and Rules," Canadian Journal of Economics, Canadian Economics Association, vol. 16(1), pages 1-16, February.
  3. van der Ploeg, Frederick, 1987. "International Policy Coordination in Interdependent Monetary Economies," CEPR Discussion Papers, C.E.P.R. Discussion Papers 169, C.E.P.R. Discussion Papers.
  4. Taylor, John B., 1983. "`Rules, discretion and reputation in a model of monetary policy' by Robert J. Barro and David B. Gordon," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(1), pages 123-125.
  5. Yashiv, Eran, 1989. "Optimal inflation and the government revenue mix," Economics Letters, Elsevier, vol. 31(2), pages 151-154, December.
  6. Calvo, Guillermo A, 1978. "On the Time Consistency of Optimal Policy in a Monetary Economy," Econometrica, Econometric Society, Econometric Society, vol. 46(6), pages 1411-28, November.
  7. Canzoneri, Matthew B & Rogers, Carol Ann, 1990. "Is the European Community an Optimal Currency Area? Optimal Taxation versus the Cost of Multiple Currencies," American Economic Review, American Economic Association, vol. 80(3), pages 419-33, June.
  8. Casella, Alessandra, 1992. "Participation in a Currency Union," American Economic Review, American Economic Association, vol. 82(4), pages 847-63, September.
  9. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(1), pages 101-121.
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Cited by:
  1. Mourmouras, Iannis A. & Su, Dou-Ming, 1995. "Central bank independence, policy reforms and the credibility of public debt stabilizations," European Journal of Political Economy, Elsevier, vol. 11(1), pages 189-204, March.
  2. Schaling, E., 1993. "On the economic independence of the central bank and the persistence of inflation (Second revision)," Discussion Paper, Tilburg University, Center for Economic Research 1993-36, Tilburg University, Center for Economic Research.

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