Introduction

Very few economists would nowadays deny that the stock of money and the price level are closely related variables. In fact, cross-country empirical analyses (see, e.g., Vogel, 1974; Lucas, 1980; Lothian, 1985; Calvo, 1987) and even a cursory look at the data eloquently shows that a nonbeliever in this basic ‘monetarist’ proposition would have a hard time making his case (except, perhaps, for recent periods when the very definition of the relevant stock-of-money concept is somewhat controversial). However, if money growth is the main cause of inflation, and the relationship is well understood, why is it then that inflation has not been completely eradicated? A possible answer is that at times countries rely on the inflation tax as a source of fiscal revenue. In fact, Phelps (1973) has given rise to a literature which suggests that a sensible reliance on the inflation tax could even be socially optimal (see, e.g., Végh, 1989; Guidotti and Végh, 1988; and the references therein). Interestingly, however, there are many instances in which the inflation tax appears to be larger than any sensible social welfare function would dictate. The phenomenon becomes self-evident in hyperinflation episodes. An answer to this puzzle was given in Calvo (1978) where it is shown that money creation becomes an attractive fiscal revenue source when its present use has little effect on expectations about future monetary/fiscal policy (a characteristic of non-reputational rational-expectations equilibria). Thus, for each successive government it is optimal to engineer ‘high’ inflation.