SETASIGNThis e-book
B) Second hypothesis
3. The long term adjustment
6.1 Government budget constraints
Advanced Macroeconomics
191
International adjustments: Policy implications
6 International adjustments:
Policy implications
Advanced Macroeconomics
192
International adjustments: Policy implications In the short run, a rise in the deficit may cause a rise in the interest rate because of the government’s expansionary fiscal policy. But the goal is not to increase the interest rate. A government monetizes its deficit when it purchases a part of the debt sold by the treasury to finance the deficit. The government faces a dilemma whether to monetize the deficit or not. A fiscal expansion unaccompanied by supporting monetary policies raises the interest rate and thus crowds out private expenditures. The government buys securities, thereby increasing the money supply, and allowing an increase in income without raising the interest rate.
If there is full employment, then the monetization of debt could lead to inflation. Higher aggregate demand will lead to a rise in the real interest rate. Crowding out will occur and lead to high inflation.
The government should supply money at a constant level and at the same time, allow the interest rate to gradually rise. At full employment, this could lead to inflation. An unwise fiscal expansion could lead to more monetary expansion. It depends on the government whether to pursue an accommodating monetary policy or whether to stay with an unchanged monetary target or even offset a fiscal expansion by a tightening of monetary policy. The government has to compare the costs of higher inflation with those of higher unemployment whenever an expansionary policy threatens to cause inflation. In India, inflation in non-fuel commodities is seen as a more important driver of domestic inflation than fuel.
The exchange rate passing through a co-efficient is found to be modest, but nonetheless, a sharp depreciation in a short period of time can add to inflationary pressures (Kapur 2012). High output growth and low inflation are among the most important objectives of macroeconomic policy. But there is a perceived tradeoff between lowering inflation and achieving high growth. Empirical evidence emphasizes that the growth-inflation relationship depends on the level of inflation at some low levels. Inflation may be positively co-related with growth but a higher level of inflation is likely to be harmful to growth. In other words, the relationship between inflation and output growth is nonlinear (Mohanty et.al. 2011).
Advanced Macroeconomics
193
International adjustments: Policy implications
6.1.1 The inflation tax
The government prints money and increases the supply of high powered money. This source of revenue is sometimes known as seigniorage which is the government’s ability to raise revenue through its right to create money. When a government finances its deficit by creating money, then money can be printed period after period. This money is used to pay for the goods and services the government buys. This money is absorbed by the people. In the long run, prices rise then the purchasing power of a given stock of nominal balances falls. To maintain a constant real value of money balance, the people have to add to their stock of nominal balances at a rate that will exactly offset the effects of inflation. When the people do so, they simultaneously use a part of their income to increase their holding of nominal money. People do this to prevent their wealth from declining as a result of inflation. Inflation acts just like a tax because people are forced to spend less of their income to be able to pay the difference to the government in exchange for the extra money. Therefore, a government can thus spend more in an economy while the public spends less. The government has the resources to finance extra spending.
When a government finances its deficit by issuing money, the public adds to its holding of nominal balances to keep the real value of money balances constant. It means the government is financing the deficit through the inflation tax.
If output is constant then,
ITR = IR*RMB
where ITR = inflation tax revenue IR = inflation rate
RMB = real money base
The inflation tax is clearly distortionary, but so are the other alternative taxes. Many of the distortions from inflation come from a tax system that is not inflation neutral; for example, from nominal tax brackets or from the deductibility of nominal interest payments. These could be corrected by allowing for a higher, optimal, inflation volatility-indexed bond that can protect investors from inflation risk (Blanchard et.al. 2003).
J
F
,5
7D[UHYHQXHV
,5
$$
ʌʌ
,QIODWLRQUDWH Figure 6.1 Inflation and tax revenues
Advanced Macroeconomics
194
International adjustments: Policy implications When inflation is zero, the government gets no revenue from inflation. As the inflation rate rises, the amount of inflation tax received by the government also increases. But as the inflation rate rises, people reduce their real holding of the money base. This is because the base is becoming increasingly costly to hold. Individuals hold less currency and banks hold as few excess reserves as possible. The real monetary base falls so much that the total amount of inflation tax revenues received by the government falls.
At the starting point c this signifies that there is a maximum amount of revenue that the government can raise through the inflation tax. The maximum is shown as IR*. The inflation rate, denoted as π*, is the steady state inflation rate at which the inflation tax is at its maximum. At this initial point, there is no inflation and no printing of money. But in the long run, the government cuts taxes and finances the deficit by printing money. The deficit is at IR’ and inflation in the economy is π’. But at the second point, the government wishes to increase revenues. The economy is on the rising part of the curve. The government deficit is also at the high (IR*) rate. In less developed countries, the banking sector is also less developed. People hold maximum cash balances. The government gets its revenue from inflation.