Working Paper: NBER ID: w2869
Authors: Maurice Obstfeld
Abstract: This paper shows that the optimal extraction of seigniorage implies a strong tendency for inflation to fall over time toward its socially optimal level. The point is made using a multi-period model in which (i) the government can finance deficits through bond issue or money creation, (ii) private-sector expectations are rational, and (iii) the government sets the inflation rate each period in a discretionary manner. One way to view the model is as a synthesis of the "tax-smoothing" theory of government deficits, which predicts that the inflation tax follows approximately a martingale, and of models of discretionary policy making, which predict (absent reputation effects) that inflation is likely to exceed its socially optimal level. Both predictions are modified when the two approaches to explaining inflation are merged. Reputation effects play no role in the analysis.
Keywords: seigniorage; inflation; government policy; tax smoothing
JEL Codes: E31; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Optimal extraction of seigniorage (H21) | Inflation tends to decline over time toward its socially optimal level (E31) |
| Government financing deficits through money creation (E62) | Higher inflation than socially optimal levels (E31) |
| Discretionary policymaking (E60) | Inflation exceeding its optimal level (E31) |
| Government policies and private expectations interact (D84) | Shape inflation dynamics (C69) |
| Inflation rates display a tendency to revert to a low mean level (E31) | Government policies and private expectations (D84) |