Fiscal Crisis Resolution: Taxation versus Inflation

The paper presents a model of fiscal and monetary policy that evaluates the tradeoff be­ tween higher distortionary labor taxation and higher ination in the resolution of fiscal crises. In the model government debt is domestically held and nominal. Data are presented to show that such debt is now at least as important as external government debt in many key emerg­ ing markets, and that it is a very important item on the balance sheets of domestic financial intermediaries, despite the disappearance of financial repression. In the model government debt correspondingly enters the economy’s intermediation technology. The key contribution of this mechanism is that it makes unanticipated ination costly. This permits a general­ ization of existing fiscal theories of the price level by making price level determination the outcome of an explicit government optimization problem over a tax distortion and an in­ ation distortion. Higher taxes have a distortionary effect on labor supply but a beneficial effect by lowering ination and supporting a higher public debt stock that in turn supports intermediation and the capital stock. In such a model first period price level jumps generally do not contribute to the resolution of fiscal crises. Instead ongoing but modest ination is used to levy seigniorage on debt. This gives rise to a fiscal theory of ination whose transmission mechanism does not rely on base money seigniorage. It is found that a large contribution of ination to the resolution of a fiscal crisis is only optimal when the fiscal shock is transitory, while a long­lived shock is optimally financed mostly through taxes. The author thanks Guillermo Calvo, Bob Hall, Ken Judd, Enrique Mendoza, Evan Tanner, Mark Wright and seminar participants at UC Santa Cruz and Stanford for helpful comments. Major parts of this research were completed while the author visited the Hong Kong Institute for Monetary Research, the Research Departments of the IMF and the IDB, and the IMF Institute. Their support is very gratefully acknowledged.