The government runs a deficit and pays for the goods and services with newly printed money. The private sector's agents' nominal balances (holdings of high-powered money) then rise. Assuming that there is no real income growth, the quantity of goods and services will be constant. Therefore the new demand created by the government will drive up prices. Inflation will be in step with the higher nominal holdings so that purchasing power remains constant. People add to their nominal balances to offset the inflation (to keep their real wealth the same). Some of the public's income is now used to add to nominal balances to counter higher prices. In this way the inflation acts as a tax. People are forced to spend less than their income and pay the difference to the government to receive the extra money. The private sector has the same real balances but fewer goods. The government gained goods and services simply by issuing money. The extra expenditure has been financed by the inflation tax.
The amount of revenue from an inflation tax is not unlimited. Revenue is equal to the product of the tax rate and the tax base, in this case the inflation rate and the real monetary base respectively, as shown in equation 2 (Assuming real output constant).
Equation 2:
IR = P' * S
where IR = inflation tax revenue
P' = inflation rate
S = real monetary base
Thus the revenue is zero when inflation is zero, and rises as the rate of inflation rises. After a certain point the revenue will fall as inflation makes it more expensive to hold high-powered money. This relationship is illustrated in Figure 1.
In industrialized countries such as the UK the monetary base is small compared to the size of the economy and the inflation rate kept low. An inflation of 2.5% and M0 at 3% of GDP (M0 as percentage of GDP in 1990/91, 1991/92 and 1992/93 were 3.33%, 3.24% and 3.27% respectively) would only yield an inflation tax revenue of 0.075% of GDP. This is not likely to be a major source of government revenue considering that the Public Sector Borrowing Requirement (PSBR) was 3.8% of GDP in 1991/92 and 7.4% in 1992/93. It is thus unlikely that the UK government will set inflation (by issuing money) with revenue as the main criterion. Indeed the current government is pledged to keep the inflation rate down and sets out guidelines for the growth of M0 in the Medium Term Financial Strategy.
The UK government will be careful to avoid the hyperinflation suffered in the Latin American countries in the mid-1980's. Nicaragua suffered 23710% inflation in 1989 and this is almost certainly partly attributable to the desire to raise revenue in the manner outlined above. The desire to keep inflation low and the relatively low yield of an inflation tax are likely to induce the UK government to try to finance expenditure by other means.
Being a developed country the government can raise a large amount of money through explicit taxation rather than the implicit inflation tax method. However, the PSBR statistics show a large shortfall between taxation revenue and spending over recent years. This is likely to be explained by political reasons in that high taxes are unpopular. It is likely that expenditure has risen relative to taxes over the long run due to the adverse electoral effects of taxes.
The second standard method of financing a deficit is by debt financing. Instead of issuing money the government can borrow from the private sector by issuing government debt or bonds. Bonds are auctioned to potential buyers regularly. Much of the debt is to finance maturing debt rather than the current deficit and the method by which the public sector finances and refinances the national debt is known as debt management. Sargent and Wallace explain the procedure but criticise it suggesting it would be even more inflationary than monetary financing. The government runs a deficit and defers payment by selling more bonds (in Equation 1 B rises). The rational agents (rational expectations is a central assumption of the paper) realise that the eventually the government will have to pay the debt (B will equal 0). In the last period the government must print money to pay the debt which leads to inflation. Again the rational agents predict this and start to guard against inflation now. This becomes self-fulfilling and inflation occurs now. If the interest payments exceed the economy's discount rate the inflation could be greater than if money was issued instead of bonds.
This idea can ,however, be refuted by considering that there will be no demand for money in the last period. All three motives for holding money: precautionary, speculative and transactionary all require the existence of another period. If there is no demand for money in the last period (St = 0) then rational expectations suggest no inflation. Ultimately it seems an unlikely assumption that agents consider the "final" period when buying bonds. They will probably not make the connection between demand for bonds in any period being zero and thus cause expectations-augmented inflation. It seems less clear that bond-financing leads to inflation.
Another criticism of bond-financed expenditure is the crowding out effect. In order to sell the bonds the government must award an attractive interest rate (low price on the bonds) and this will raise the interest rates generally. Thus some private sector investment is "crowded out". This is of limited effect according to Keynsians who see investment as interest-insensitive. However, with the assumed constant real output there is some unambiguous crowding out of private sector consumption as explained earlier.
A more recent addition to the government's tool cabinet is privatization. The revenue from this policy is considered negative government expenditure and thus helps to pay for government spending and reduce the deficit. This revenue is very significant in the UK at the present with privatization raising £7.9 billion, £8.2 billion and £5.4 billion in 1991/92, 1992/93 and 1993/94 respectively. Thus the need for the UK to issue money to gain real resources is reduced by this extra reduction to the PSBR.
Another consideration is that the UK may lose its sovereignty in printing money in the future. If the country enters the Economic and Monetary Union (EMU) and plumps for a single European currency (European Currency Unit: ECU) it will not have as much power to issue high-powered money to finance its deficits. However, this is not at present the case and the amount of control the national government will retain if it becomes the case is not yet known.
It therefore seems that the UK will use all three methods of gaining real resources (explicit taxation, bond-financed deficit and money-financed deficit. Privatization is included as negative expenditure) in different degrees depending on other political and economic aims. For instance, taxation is limited due to its unpopularity and political consequences, money financing by the threat of inflation and its limited yield and bond financing by the possible (but ambiguous) inflation aspects and its continual increasing of the debt with interest payments rising. The issuing of money to gain real resources is a possibility in the UK but not likely to be the main method with bond-financing seeming more attractive and taxation and privatization covering a significant amount of the shortfall.
Bibliography
- R.Dornbusch and S.Fischer, Macroeconomics, Fifth ed, (1990)
- R.Levacic and A.Rebmann, Macroeconomics: An Introduction to Keynesian-Neoclassical Controversies, Second ed, (1986)
- E.Seddon, Advanced Economics, (1987)
- J.Beardshaw, Economics: A Student's Guide, Second ed, (1986)
- R.Barro, Money, Expectations and Business Cycles, (1981)
- Central Statistical Office, Financial Statistics, (June 1994)
