DP15299 Monetary Capacity

Author(s): Roberto Bonfatti, Adam Brzezinski, Kivanç Karaman, Nuno Pedro G. Palma
Publication Date: September 2020
Keyword(s): fiscal capacity, inflation, monetary capacity, monetary non-neutrality, monetization, Quantity Theory of Money, taxation
JEL(s): E50, E60, H21, N10, O11
Programme Areas: Public Economics, Economic History, Monetary Economics and Fluctuations, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15299

Monetary capacity refers to a state's capacity to circulate money that is accepted by the public, whereas fiscal capacity refers to its capacity to tax. In this paper, we show both theoretically and empirically that monetary and fiscal capacity, and by extension, markets and states have a symbiotic relationship. On the theoretical front, we propose a model that establishes that a higher monetary capacity incentivizes the government to invest in the capacity to tax, because monetization eases taxation. Higher fiscal capacity, in turn, increases the public demand for money, because expected inflation is lower. On the empirical front, we find that monetary capacity had a significant and substantial causal impact on fiscal capacity. To identify this impact, we rely on a natural experiment, instrumenting the money stocks of England, France and Spain between 1550 and 1790 by the silver and gold output in the New World. Finally, to put our findings into a long-run perspective, we collect money stock and tax revenue data for European states from antiquity to the modern period, and document the close relationship between the two. These findings indicate that economic and political development cannot be understood independently. They also qualify the theory of the long-run neutrality of money: exogenous changes in money stock can and did have real long-run effects.