Financing government expenditure �Public Economics ECON5519

21 August 2025 (week 5), 10:00-1:00, BUSN: G42

• Ken Clements
• Financing government expenditure, including via the central bank
• See me if you wish to clarify (email to set a time ken.clements@uwa.edu.au)

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• Need a volunteer timekeeper
• Slides available on LMS

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1

Inflation, Australia�(% per annum)

Source: RBA Inflation Target | RBA

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• Inflation now back within 2-3% band
• Interest rates now coming down
• Uncertainty if inflation will remain low
• RBA only slowly reducing interest rates
• Balance

(i) Not tanking the economy with keeping interest rates too high for too long

(ii) Avoiding higher inflation by lowering interest rates too soon and too much

• Aim for “soft landing” with low inflation/interest rates/unemployment
• Major uncertainties: Trump, China, Europe

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Recent monetary policy

0. Monetary policy

Pressures on RBA

• Objective of RBA: Get inflation back into 2-3% range
• RBA sets the cash rate
• One of the most prestigious institution in the country
• But subject to considerable pressures and turmoil

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• RBA independent central bank, like many others
• Inflation target 2-3% on average over the course of the cycle
• Costs of too-high inflation – redistributions of incomes and wealth, decreased functions of money as store of value and unit of account
• Too-low inflation bad also – zero lower bound problems; can lead to deflation which increases real value of debts and possibly leads to depression; omission of quality improvements in inflation measures
• Inflation target should balance these considerations
• If target missed consistently, central bank’s credibility damaged

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Longer-term

monetary policy

What does “independence” �mean for a central bank?

• Monetary policy easy to change – fast, no legislative changes needed
• CB officials unelected – undemocratic to make them independent?
• Time-inconsistency problem: Example

(i) Govt commits to the longer-term objective of low inflation

(ii) But when economy floundering and election looming, govt has incentive to inflation to stimulate economy

(iii) People come to expect this inconsistent behaviour. Expected inflation is ratcheted upwards, leading to higher inflation as CB loses credibility

• Independence of CB designed to avoid time inconsistency

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Is the RBA independence?

• What are the issues?

(i) Who hires and fires senior RBA staff. Treasurer (a politician)

(ii) Who’s on RBA Board. Secretary of Dept of Treasury (whose boss is Treasurer)

(iii) Not-so-subtle public statements by PM, Treasurer, etc.

• Not a conspiracy, a problem of the practice of central banking
• CBs around the world grapple with these issues

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• RBA good place for young graduates to work

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Summary of lecture

1. Public economics fundamentals
2. Three sources of finance to government
1. Borrow from central bank. Printing money. Inflation.
2. Borrow from public. Debt-financed deficits. Future interest and principal payments. Higher future taxes. Maybe same as higher current taxes (Ricardian equivalence).
3. Higher taxes. Distorts economic activity. Efficiency costs. Optimal taxation
3. Social opportunity cost of capital

What discount rate to use for public projects? Weighted average of (i) time preference and (ii) marginal productivity of capital. Weights reflect where funds come from. Ramsey’s discount rate.

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Summary

Table of contents

1. Public finance fundamentals

2. Central-bank financing

3. Debt

4. Taxation

5. Opportunity cost of capital

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1. Public finance fundamentals

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1. Fundamentals

2. Central-bank financing

Summary

• Money-creation
• Money and inflation
• Inflation tax
• Revenue from inflation
• Welfare cost of inflation
• Hyperinflation

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2. CB financing

Balance sheet of central bank

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2. CB financing

Money creation

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Money demand

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Time path of inflation

(Assume: m = M/P = constant

in steady state)

Time

%Δ

%ΔP

%ΔM

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Possible transitional path

Time

%Δ

%ΔP

%ΔM

%ΔM > %ΔP and therefore the level of m is increasing

%ΔM < %ΔP and therefore the level of m is decreasing

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%Δm

m = M/P

0

Real money balances

In steady state, m = constant, %Δm = 0, and so %ΔM = %ΔP

Change

Level

Time

Time

Summary of monetary dynamics

Quantity theory of money

• Quantity theory one of the oldest in economics
• Seems to have worked well over longer term (but controversial)
• Covid: Massive expansion of CB balance sheets (“quantitative easing”), then unwinding (“quantitative tightening”)
• Led to inflation surging around the world, now down
• QTM due for a comeback
• For introduction to QTM, see Clements (2017)

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An excise tax

The demand for beer:

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A

B

C

D

Quantity of

beer demanded (litres)

Price

per litre

ABCD = tax revenue

Beer

demand

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m

i

A

B

C

D

Money

demand

Seigniorage

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Does higher inflation

always mean more revenue?

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Money

demand

i

C

D

A

B

m

Revenue falls if �money demand sufficiently elastic

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Laffer curve

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Milton Friedman�(1912-2006)

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Friedman’s road

• Friedman's example of a road financed by money creation (Friedman and Friedman, 1980, Free to Choose, Chpt 9 )
• Who really pays? Where do the real resources come from?
• Money holders pay as the construction of the road is inflationary
• They now acquire more nominal balances to keep their real balances constant
• They must refrain from spending. That’s where the real resources come
• The extra money people hold is the receipt for (the hidden) taxes paid

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An interest-free loan

• The inflation tax arises because holding money is like giving the government an interest-free loan
• The higher is inflation, the higher are interest rates and the higher is the subsidy that money holders give the government
• This is the inflation tax

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Who said this?

“It is common to speak as though, when a government pays its way by inflation, the people of the country avoid taxation…What is raised by printing notes is just as much taken from the public as is beer-duty or an income-tax. What a government spends the public pay for…[I]t seems possible to please and content the public, for a time at least, by giving them, in return for the taxes they pay, finely engraved acknowledgments on water-marked paper.”

J. M. Keynes Monetary Reform 1924

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Alternative theories of inflation

I. Modern monetary theory

1. Government can’t run out of “money” when it creates its own money
2. When government debt is denominated in its own currency, it can always be serviced simply by creating money
3. Government deficits and the accumulated stock of debt don’t constrain macroeconomic management
4. Fiscal policy can be directed at maintaining economic activity and managing unemployment

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Letter to Editor�The West Australian, 27 April 2024

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As Senior Adviser to the Prime Minister, he asks you to evaluate this argument.

Alternative theories of inflation (cont’d)

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Alternative theories of inflation (cont’d)

• III. The mega-event theory
• Taylor Swift

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• Economist (2023). “Can Superstars like Beyoncé or Taylor Swift Spur Inflation?”
• Change in relative price versus a change in the price level
• “See through” these blips

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Fisher, price level �versus relative prices

• Irving Fisher (1867-1947) was a great monetary economist
• Also colourful and controversial – made and lost a great fortune
• Fisher describes distinction between relative price changes and changes in the price level as:
• “It is possible to study the general level of price independently of particular prices, just as it is possible to study the general tides of the ocean independently of its particular waves.” (Fisher, 1910, p. 134)
• For more from Fisher on this and the QTM, see the end of these slides

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Inflation policy�(True, false or uncertain and why)

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Inflation policy�(True, false or uncertain and why)

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Welfare cost of inflationary finance

The beer tax again:

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A

B

C

D

q

p

E

Beer

demand

Size of triangle

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Nature of welfare cost

• When inflation is higher, money loses part of its function as a medium of exchange and store of value
• Individuals seek out substitutes for money -- other financial assets, barter
• Welfare cost of inflation measures the real resources devoted to economising on money holdings
• Individuals hold less money
• Companies devote valuable executive time to “cash management” rather than producing widgets
• Extreme example: Hyperinflation

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Hyperinflation

• When inflation exceeds 50% per month
• Bus versus taxi
• For the bus, you pay in advance. For taxi, you pay at the end
• Cheaper to pay at the end because money has lost so much value during the taxi ride!

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German hyperinflation, 1920s

References: Bailey (1956), Cagan (1956)

• German Weimar Republic – borrowings, WWI, reparations
• Hyperinflation September 1920 - November 1923
• Maximum rate of inflation 39.8% per day
• Extreme case of government financing its deficit by printing money
• Government tried to increase (or simply maintain) the real value of the revenue form inflation by printing more of the stuff
• Friedman (1970) argues that the German hyperinflation “laid the groundwork for Hitler”

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Tending toward barter

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Costs of hyperinflation

The disruptive effects of the German hyperinflation is vividly described by Bailey (1956):

“…firms began to pay their workers more and more frequently: first weekly, then daily, and then sometimes twice a day or more.

[After being paid] workers …rushed to purchase consumer goods, foreign currencies or other assets. Shopkeepers tended to close early … to exchange their newly acquired cash at once for inventories.

…[S]ome firms paid workers in kind rather than with cash….”

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Why care about hyperinflation?

• Recent high inflations: Argentina, Lebanon, Venezuela, Zimbabwe, various Latin American countries
• Will high inflation spiral into hyperinflation?
• Why study hyperinflation? Reveals hidden monetary phenomena. Like a laboratory experiment
• Teaches us about:
1. Why money was such a useful economic invention
2. The quantity theory of money
3. Public finance: Government revenue from inflation

For information on periods of hyperinflations, see Hanke and Krus (2013) and

https://www.cato.org/sites/cato.org/files/pubs/pdf/hanke-krus-hyperinflation-table-may-2013.pdf

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3. DEBT

Reference: Barro (1989)

• See attached notes
• Ricardian equivalence
• Modigliani-Miller theorem
• No free lunches

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3. Debt

3. Debt

Contents

• Three costs of taxes
• The welfare cost
• Optimal taxation

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4. Taxation

4. Taxation

Three costs of taxes

1. Administrative costs. For example, cost of running the Australia Tax Office
2. Compliance costs to taxpayers. Time spent record keeping and compiling tax forms. Fees paid to tax accountants. Inconvenience and heightened anxiety
3. Efficiency loss, the “welfare cost”

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Welfare cost of �an excise tax

Beer tax again:

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A

B

C

D

q

p

E

Beer

demand

Taxes on many goods

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Welfare cost with many taxes

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Optimal taxation

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Optimal taxation

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Three special cases, I

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Three special cases, II

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Three special cases, III

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Contents

• Project evaluation
• Importance of the discount rate
• Harberger’s discount rate
• Ramsey’s discount rate

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5. Opportunity cost of capital

Project evaluation

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Harberger’s discount rate

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Arnold Harberger�(1924- )

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See Dougan (2022) for a brilliant interpretation of

Harberger’s contributions

Intertemporal optimisation

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Ramsey’s social discount rate

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Difficulties

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References

Bailey, M. J. (1956). “The Welfare Cost of Inflationary Finance.” Journal of Political Economy 64(2): 93-110.

Barro, R. J. (1989). “The Ricardian Approach to Budget Deficits.” Journal of Economic Perspectives 3: 37–54.

Burns, J. (2024). Milton Friedman: The Last Conservative. New York: Farrar Straus Giroux.

Cagan, P. (1956). “The Monetary Dynamics of Hyperinflation.” In M. Friedman, ed., Studies in the Quantity Theory of Money. Chicago: The University of Chicago Press.

Clements, K. W. (2017). “Notes on the Quantity Theory.” Lecture notes.

Cochrane, J. H. (2023). The Fiscal Theory of the Price Level. Princeton and Oxford: Princeton University Press.

Dougan, W. (2022). “Arnold C. Harberger (1924-).” In R. Cord (ed.), The Palgrave Companion to Chicago Economics. Palgrave Macmillan, London. [Available on LMS.]

Dornbusch, R., and S. Fischer (1993). “Moderate Inflation.” World Bank Economic Review 7: 1-44.

Economist (2023). “Can Superstars like Beyoncé or Taylor Swift Spur Inflation?” July 25 https://www.economist.com/the-economist-explains/2023/07/25/can-superstars-like-beyonce-or-taylor-swift-spur-inflation

Fisher, I. (1910). Introduction to Economic Science. New York: Macmillian. https://fraser.stlouisfed.org/files/docs/publications/books/introeconomic_fisher.pdf

Fisher, I. (1911). “Recent Changes in the Price Level and Their Causes.” American Economic Review 1: 37-45.

Fisher, I. (1920). Stabilising the Dollar: A Plan to Stabilise the General Price Level without Fixing Individual Prices. New York: Macmillan.

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References

References (cont’d)

Fischer, S., R. Sahay and C. A. Végh (2002). “Modern Hyper and High Inflations.” Journal of Economic Literature 60: 837-80.

Friedman, M. (1970). “Inflation and Government Policy.” Lecture, Baruch College, https://miltonfriedman.hoover.org/friedman_images/Collections/2016c21/MFlecture_11_05_1970.pdf

Friedman, M. (1987). “Quantity Theory of Money.” The New Palgrave Dictionary of Economics Vol 4, Houndmills, Basingstoke: Macmillan Press. Pp. 3-20.

Friedman, M. (1971). “Government Revenue from Inflation.” Journal of Political Economy 79: 846-56.

Friedman, M., and R. Friedman (1980). Free to Choose. Melbourne: Macmillan. Chapter 9.

Hanke, S., and N. Krus (2013). “World Hyperinflations.” In R. Parker and R. Whaples (eds) The Handbook of Major Events in Economic History. London: Routledge Publishing.

Harberger, A. C. (1972). “On Measuring the Social Opportunity Cost of Public Funds.” In A. C. Harberger Project Evaluation. London: Macmillan. Pp. 94-122.

Harberger, A. C. (1978). “A Primer on Inflation.” Journal of Money, Credit and Banking 10: 505-21.

Harberger, A. C. (1971). “Three Basic Postulates for Applied Welfare Economics: An Interpretive Essay.” Journal of Economic Literature 9: 785-97.

Heckman, J. J., et al. “Arnold Harberger at 100.” https://www.youtube.com/watch?v=8Rj-GyQhPf8

Jia, K. (2019). The Economics of Hyperinflation. UWA BCom honours dissertation.

Lucas, R. E. (1980). “Two Illustrations of the Quantity Theory of Money.” American Economic Review 70: 1005-14.

Nelson, E. (2020). Milton Friedman and Economic Debate in the United States, 1932–1972. Two Volumes. Chicago: University of Chicago Press.

Ramsey, F. P. (1927). “A Contribution to the Theory of Taxation.” Economic Journal 37: 47-61.

Ramsey, F. P. (1928). ‘‘A Mathematical Theory of Saving.’’ Economic Journal 38: 543–59.

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References

Optional material

Contents

A1. RBA Review

A2. Money demand and revenue maximisation

A3. Fisher on monetary concepts

A4. Notes on Barro

A5. Harberger’s social discount rate

A6. Ramsey

A7. RBA in action

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A1. RBA Review

• Review critical of monetary policy and internal organization of RBA, 2023
• Recommended RBA get advice of external economists
• Philip Lowe former Governor of RBA replaced by Michelle Bullock

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A1 Review

A2. Money demand and �revenue maximisation

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Source: Jia, K. (2019). The Economics of Hyperinflation. UWA BCom Honours dissertation.

A2 Revenue from inflation

A3. Fisher on monetary concepts

Distinction between relative prices and the price level:

“It is just as impossible to determine the general level of prices by the supply and demand of individual commodities as to determine the general tidal level of the ocean by the winds affecting individual waves. Waves and tides are distinct and require distinct explanations. …”

“… Likewise, prices and price-levels are distinct and require distinct explanations. Just as each wave presupposes a general tidal level with reference to which it is measured, so the supply and demand on each individual commodity presupposes a general level of prices.” (Fisher, 1911)

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A3 Fisher

Money and prices

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A3 Fisher

Money and prices (cont’d)

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A3 Fisher

A4. Notes on Barro

Do budget deficits have real economic effects? Barro (1989)

Keynesian model

• Tax cut financed by borrowing stimulates economy as private sector spends more and govt spending is unchanged. Raises r and decreases capital stock
• In small open economy r constant, and budget deficit leads to borrowing from abroad, that is, current account deficit

Ricardian equivalence

• Challenges the above
• Today’s tax cuts set up future tax liabilities, whose PV = today’s tax cuts
• Increase savings today in anticipation of higher future taxes
• No first-order effects
• Controversial

Objections

1. Finite lives
2. Imperfect capital mkts
3. Non-lump-sum taxation
4. Full employment

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A4 Barro

David Ricardo

• 1772-1823
• Classical economist
• Known for the theory of comparative advantage, rents, labour theory of value, etc.
• Ricardian equivalence
• Self-made, wealthy broker, MP

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A4 Barro

A5. Harberger’s social discount rate

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A5 Harberger

A weighted-average �social opportunity cost

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A5 Harberger

Interpretation

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A5 Harberger

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Investment, I

A

B

Saving, S

i

r

Loanable-funds market

Source: Harberger (1972, p. 96)

A5 Harberger

A6. Ramsey

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A6 Ramsey

A7. RBA in action

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A7 RBA

Source: RBA Annual Report, 2022 Banknotes | Reserve Bank of Australia Annual Report – October 2022 | RBA