DP562 | Unanticipated Inflation and Government Finance: The Case for an Independent Common Central Bank


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This paper discuss the merits of an independent "EuroFed" within the context of a tax/seigniorage smoothing model for a monetary union. There is an incentive to use a surprise inflation tax to wipe out the real value of government debt and wage contracts because this allows a cut in distortionary taxes and boost employment and private consumption. If dependent central banks can pre-commit, there is no case for an independent EuroFed as this leads to a sub-optimal government revenue mix. If only an independent EuroFed can guarantee sufficient discipline, however, a case can be made for it over and above a monetary union with a non-cooperative or cooperative central bank. This case is stronger when the aversion to inflation is high, when the outstanding stock of nominal government debt is high, when the underground economy is insignificant and when there is little indexation. Even if all contracts are indexed, there is an incentive to create unanticipated inflation if money demand depends on expected inflation. If private agents are rational in their forecasts of inflation, however, government spending is financed through temporary bouts of taxation and inflation, and given that all contracts are indexed, no case for an independent central bank can be made. Competition between central banks of a monetary union induces excessive inflation, because each bank fails to internalize the externalities associated with appropriating too much seigniorage from the common central bank.