Tackling Inflation (from a Monetarist Perspective)
The term ‘monetise’, in the context of discussions on inflation, means to manipulate changes in the money supply. To understand why a government may want to ‘monetise’ its fiscal deficit, we must understand the impact of changing the money supply. Take a simple macroeconomic model, where the government budget constraint (G) is given by the sum total of the tax revenues (T) plus the change in the stock of public debt (∆B) plus change in the money supply (∆M). The inflation rate is the percentage change in the overall price level (π). The quantity theory for inflation tells us that inflation is given by the identity (gM — gY). This tells us that the inflation rate is the difference between the growth in money supply and the growth in output within an economy. Change in money supply appears in both of these terms. An increase in the money supply increases inflation. There is an excess amount of money chasing the same amount of goods (holding growth of output, gY, constant).
Governments may choose to increase the money supply for two reasons. The first is that the fiscal deficit and national debt has become to large and/or expensive to finance. Printing more money expands the government budget constraint by eroding the value of the stock of public debt. This because inflation erodes the real interest, which is the cost of borrowing. The Fisher curve expresses in the equation R = r — π, where R is the real interest rate, r the nominal interest rate and π the inflation rate. Therefore, government deficits and the accumulated national debt become cheaper to finance. Additionally, increased government borrowing (∆B) becomes cheaper. The second reason is that tax revenues are insufficient to cover fiscal deficits. Meaning the only way to finance the government budget is to increase borrowing. The government would therefore prefer to lower the cost of borrowing by increasing the money supply. The allure of high inflation rates as a result of expanding money supply act as perverse incentives for the government to artificially increase the price level in an attempt to increase the government budget constraint. The economist Tom Sargent famously said “inflation is always and everywhere a fiscal phenomenon”, alluding to the governments preference for high inflation. This is what is meant by the expression ‘monetise’ fiscal deficit.
Most dramatically, hyperinflation can occur as a result of the excess money supply. This can be seen in Zimbabwe, where inflation stands at 837.53%, as of July 2020 (Reserve Bank of Zimbabwe, 2020). In response to the ongoing hyperinflation crisis in Zimbabwe, it is tempting to advise the government to ‘just stop printing money’. This is a superficial analysis of the issue. Rather the underlying problems that lead the government to resort to the printing to press to finance their debts must be examined. The first problem could be an insufficient stream of tax revenues. Taxes in Zimbabwe, along with most developing countries, are weakly enforced with many loopholes in tax codes that result in evasion. By increasing the enforcement of taxes, the government of Zimbabwe could raise more money to finance expenditure. This means they do not need to resort to increasing the money supply to finance debts. The second problem facing the government could be misappropriated government funding. Corruption likely costs the government lots of money. Misappropriated government funds adding to the fiscal deficit could be the reason behind the government’s decision to erode the value of their debts. Proper management would reduce the waste of government resources and bring the budget under control. A smaller fiscal deficit is cheaper to finance and as a result, the government can aim to bring inflation down. Lastly, and most importantly, the absence of an independent central bank may be the cause of hyperinflation in Zimbabwe. Separating the central bank from the government reduces the government’s ability to manipulate the money supply to finance its deficits. Independent central banks do not conform to the short-sighted preferences of politicians. It is because of this that anchoring inflation expectations at a target rate leads to greater price stability. According to Robert Lucas, rational expectations go to show that inflation targets by central banks influence the behaviour of price setters in the economy, even if the target has not yet been reached (1976). Therefore the establishment of central bank independence, alongside credible monetary policy, can, over time, tame inflation at a desired target rate.
