Unanticipated Inflation and Government Finance : The Case for an Independent Common Central Bank
AbstractThis 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 InfoPaper provided by Tilburg - Center for Economic Research in its series Papers with number 9115.
Length: 40 pages
Date of creation: 1991
Date of revision:
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monetary systems ; inflation;
Other versions of this item:
- van der Ploeg, Frederick, 1991. "Unanticipated Inflation and Government Finance: The Case for an Independent Common Central Bank," CEPR Discussion Papers 562, C.E.P.R. Discussion Papers.
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- Schaling, E., 1993. "On the economic independence of the central bank and the persistence of inflation (Second revision)," Discussion Paper 1993-36, Tilburg University, Center for Economic Research.
- 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.
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