Deferred Inflation Effect

Some researchers also argue that budget deficit financing by means of accumulating domestic debt seems to just postpone the inflation tax. If government finances its deficit by printing money now, then in the future the burden of servicing existing stock of government debt will be easier. Interest payments that otherwise add to the next periods’ government expenditures will not exert additional pressure on fiscal authority and the deficit will not increase over time. As Sachs and Larrain (1993) put it, “borrowing today might postpone inflation, but at the risk of even higher inflation in the future”.

Sargent and Wallace (1981) observed, that when fiscal authority sets the budget independently, the monetary authority could only control the timing of inflation.

Let’s assume that initially there is no public debt yet and government budget is balanced. Then, however, for some reasons (tax legislation or increasing expenditures) the government starts running a deficit. If it is financed by selling domestic debt to the public, then, provided that primary deficit remains unchanged, the overall deficit will grow because of the mounting interest burden on the debt.

Later, as Sargent and Wallace (1981) stress, it may well be the case that public will be reluctant to acquire more government debt, because they will doubt the government’s ability to service it. They refer to this phenomenon as an assumption of an upper limit on the real stock of debt relative to the size of economy. Then the only option is to use money printing and to collect seigniorage. Provided that fiscal policy determines constraints for monetary policy (i.e. both policies are coordinated so as to finance the budget deficit), the monetary authority will be unable to control money supply and therefore inflation forever. In other words, taking into account the extensive bond financing of the deficit that preceded the critical moment (stock of debt has reached upper limit), “sooner or later, in a monetarist economy, the result is additional inflation” (Sargent and Wallace, 1981). It is so because the principal and interest on the debt accumulated up to now and issued to fight inflation must be financed, at least partially, by seigniorage.

However, it seems noteworthy that public-debt-financed deficits do not necessitate a future increase in inflation. The reason is that the government may temporarily defer inflationary pressure so as to implement some sort of restructuring (expenditure cuts or tax increases) before the economy closely approaches the upper limit on public debt.

Date: 2015-02-28; view: 681