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

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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Paper provided by Tilburg - Center for Economic Research in its series Papers with number 9115.

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Length: 40 pages
Date of creation: 1991
Date of revision:
Handle: RePEc:fth:tilbur:9115
Contact details of provider: Postal: TILBURG UNIVERSITY, CENTER FOR ECONOMIC RESEARCH, 5000 LE TILBURG THE NETHERLANDS.
Phone: 31 13 4663050
Fax: 31 13 4663066
Web page: http://center.uvt.nl/
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  1. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-71, October.
  2. Robert J. Barro & David B. Gordon, 1983. "Rules, Discretion and Reputation in a Model of Monetary Policy," NBER Working Papers 1079, National Bureau of Economic Research, Inc.
  3. Rogoff, Kenneth, 1985. "Can international monetary policy cooperation be counterproductive?," Journal of International Economics, Elsevier, vol. 18(3-4), pages 199-217, May.
  4. Robert J. Barro, 1982. "Inflationary Finance under Discrepion and Rules," NBER Working Papers 0889, National Bureau of Economic Research, Inc.
  5. Mankiw, N. Gregory, 1987. "The optimal collection of seigniorage : Theory and evidence," Journal of Monetary Economics, Elsevier, vol. 20(2), pages 327-341, September.
  6. Turnovsky, Stephen J. & Brock, William A., 1980. "Time consistency and optimal government policies in perfect foresight equilibrium," Journal of Public Economics, Elsevier, vol. 13(2), pages 183-212, April.
  7. Calvo, Guillermo A, 1978. "On the Time Consistency of Optimal Policy in a Monetary Economy," Econometrica, Econometric Society, vol. 46(6), pages 1411-28, November.
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