The inflation tax
Fri 6 Sep 2013 by Matt Nolan in Monetary policy

After a long period discussing tax, we are now up to the very last tax article!  The last type of taxation we are going to discuss is inflation tax.  Now to do this we cannot just say “inflation is bad”.  In truth, we need to ask how policy actions related to inflation and monetary policy can function as a tax, and why (as a result) economists often tend to steer away from forms of inflation taxation and direct money financing of deficits when discussing optimal tax policies.

Inflation in the context we are describing is persistent growth in the general price level – think of it as the way the real buying power of money declines, relative to goods and services, through time.

In 1978, Stanley Fisher and Franco Modigilani stated the following:

There is no convincing account of the economic costs of inflation that justifies the typical belief — of the economist and the layman — that inflation poses a serious economic problem, relative to unemployment

To be fair Fisher and Modigilani then go on to discuss many of the costs that are involved in a fairly sophisticated way.  When I studied undergraduate economics I couldn’t appreciate these costs, with appeals to “shoe leather costs” and “menu costs” from inflation sounding overstated.  If the increase in inflation also increased nominal wages then what was the problem?

In the end, the argument always seemed to be a call that “any drop in unemployment from boosting inflation is temporary, while the costs of higher inflation are permanent”. 

While this is all well and true, it came off as a very uncompelling argument – I was not convinced it mattered.  So while this is the argument you’ll often hear, I intend to flesh the details out a little more here in a hopefully accessible way.

Eventually I was taught a different way to think about the issue of inflation – by using the framework we have discussed for tax, and as a result considering what specific policy choices about money financing would have on the underlying distribution of goods and services!

Monetary policy, inflation, unemployment, and co-ordination

Before we can clearly think about issues involving inflation, we need to briefly think about the macroeconomic situation more generally. 

Previously the forms of taxation we’ve discussed, where there has been a focus on the long-run, and in the case of externality taxes where the markets of interest are small relative to the economy, focused on microeconomic arguments.  Now “microeconomics” does not mean small, it can indeed be over an entire economy (the idea of general equilibrium) – and it offers the logic we would like to use to understand the issue as a tax.

But inflation and money are a macroeconomic phenomenon.  The difference with “macroeconomics” is that it involves thinking about concepts that are aggregations of smaller components, but that we may not be able to easily break down.  The key macroeconomic variables we think about are inflation, money supply, unemployment rates, and gross domestic product.

Microeconomic arguments underlie these macroeconomic ideas, but ultimately as macroeconomists we recognise that individuals are making choices relative to these macroeconomic variables (as well as other things) and their expectations about them.  In that context, government policy can help to co-ordinate expectations about all these different macroeconomic variables.  Note:  A neat way of looking through one of the channels this runs through has been discussed recently here and

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