4 Money and Public Finance

4.1 Introduction

Inflation is a tax. And as a tax, it both generates revenue for the government and
distorts private sector behavior. The previous two chapters focused on these dis-
tortions. In the Sidrauski model, inflation distorts the demand for money, thereby
generating welfare e¤ects because real money holdings directly yield utility. In the
Cooley-Hansen cash-in-advance (CIA) model, inflation serves as an implicit tax on
consumption, so a higher inflation rate generates a substitution toward leisure, lead-
ing to lower labor supply, output, and consumption.
In our analysis of these distortions, we ignored the revenue side of the inflation tax
except to note that the Friedman rule for the optimal rate of inflation may need to be
modified if the government does not have lump-sum sources of revenue available.
Any change in inflation that a¤ects the revenue from the inflation tax will have
budgetary implications for the government. If higher inflation allows other forms of
distortionary taxation to be reduced, this fact must be incorporated into any assess-
ment of the costs of the inflation tax. In this chapter, we introduce the government
sector’s budget constraint and examine the revenue implications of inflation. Doing
so allows us to focus more explicitly on the role of inflation in a theory of public
finance and to draw on the literature on optimal taxation in analyzing the e¤ects of
inflation.
A public-finance approach yields several insights. Among the most important is
the recognition that fiscal and monetary policies are linked through the government
sector’s budget constraint. Variations in the inflation rate can have implications for
the fiscal authority’s decisions about expenditures and taxes, and, conversely, deci-
sions by the fiscal authority can have implications for money growth and inflation.
When inflation is viewed as a distortionary revenue-generating tax, the degree to
which it should be relied upon depends on the set of alternative taxes available to the
government and on the reasons individuals hold money. Whether the most appro-
priate strategy is to think of money as entering the utility function as a final good or
as serving as an intermediate input into the production of transaction services can
have implications for whether money should be taxed. The optimal-tax perspective
also has empirical implications for inflation.
In the next section, the consolidated government’s budget identity is set out, and
some of the revenue implications of inflation are examined. Section 4.3 introduces
various assumptions that can be made about the relationship between monetary and
fiscal policies. Section 4.3.1 discusses situations of fiscal dominance in which a fixed
amount of revenue must be raised from the inflation tax. It then discusses the equi-
librium relationship between money and the price level. Section 4.3.2 turns to recent
theories that emphasize what has come to be called the fiscal theory of the price level.