European Monetary Union
Rules for the Eurofed?

The 1989 Delors Report's recommendation that the European Community set upper limits on member states' public sector borrowing requirements to safeguard monetary and exchange rate stability seems ill-conceived, since financial markets can deal with governments whose finances get out of hand. Both the 1989 Delors Report and the Commission's 1990 Report, `One Market, One Money', recommended that member states be forbidden to finance expenditure by printing money, which means in practice that the new Eurofed be independent and free of political pressures to accommodate demands for increased public spending or wages.

In Discussion Paper No. 562, Research Fellow Frederick van der Ploeg assesses the case for an independent Eurofed, from the perspectives of stabilization and public finance. This depends critically on its ability to precommit to the supply of a stable quantity of high-powered money, which it can only achieve if it is directed by ultra-conservative central bankers. An independent Eurofed's strong anti-inflationary discipline carries with it a lack of flexibility to conduct active monetary policy for purposes of stabilization or enhancing government revenues.

Van der Ploeg integrates the Barro-Gordon theories of inflation with the tax/inflation smoothing theories of Mankiw and others, to model governments' incentives to use a surprise inflation tax, focusing on nominal debt and wage contracts whose value may be eroded through unanticipated inflation. The first-best policy is a reform of the labour market structure: with the government issuing indexed rather than nominal bonds and wage and all other contracts indexed to the price level, incentives for surprise inflation would disappear. When governments can precommit to budgetary policies, the absence of policy coordination within the union leads to high inflation and monetary growth and low non- monetary tax rates; and member countries' do not internalize the adverse effects of extracting too much seigniorage from the common central bank. When governments cannot precommit, inflation is higher and tax rates lower. If central bankers can precommit, there is no case for a common central bank; while if they cannot precommit, there is such a case, which increases with the nominal government debt and inflation aversion.

Van der Ploeg then extends the model to allow for the effects of unanticipated inflation on unemployment and private consumption. If money demand depends negatively on expected inflation, governments take account of private agents' economizing on money holdings, and optimal inflation is lower, which further strengthens the case for an independent Eurofed. Finally, applying recent work by Calvo and Obstfeld on the strategic interactions between an optimizing government and a rational private sector to a monetary union, van der Ploeg shows that governments that cannot commit to preannounced monetary policies may not always find it optimal to smooth seigniorage revenues and inflation rates.

Unanticipated Inflation and Government Finance: The Case for an Independent Common Central Bank
Frederick van der Ploeg

Discussion Paper No. 562, August 1991 (IM)