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  • The Value Of Money Revisited: Musings On Inflation 0 comments
    Dec 8, 2012 2:42 AM

    I'd like to look back at the stories about the origin of money that economics professors tell their students. Students are told that Federal Government Bank Notes were adopted by consumers as they were the only accepted method of payment for Federal Taxes. Although there were many competing forms of money, there was always someone willing to accept these Federal notes as a payment for debt. Likewise, these debts were also very reliable, as the saying goes: "there are only two things that are certain in life, death and taxes". So the necessity of use and reliability of need caused Federal Bank notes to be the most accepted form of money in the country.

    I'm not here to question whether or not this story is true. I'd like to introduce this story into the conversation about inflation, specifically, the conversation about hyperinflation. Pundits who claim the sky is falling point to recent monetary action as the precursor to explosive hyperinflation. They paint pictures of trillion dollar Zimbabwean bills and walls covered in German Marks. But to my knowledge no one has considered taxes as an anchor between nominal income and prices.

    For the sake of this discussion, let's assume a 30% flat tax rate. Let's also state that taxes are paid yearly based on a fraction of that year's nominal income.

    I suspect that the continued existence of taxes dampens the impact of runaway inflation by tying some portion of consumer income to a fixed nominal expenditure. Therefore taxpayers will be spending a fixed amount of money on taxes each year. So taxes reduce the amount of individual income that is sensitive to a change in the price level.

    For example, imagine some economy experienced inflation in such a way that there was now an extra dollar chasing the same amount of goods. If this is an economy that experiences taxes then that dollar would in fact be 70 cents. Simply, the result is fewer new dollars chasing the same number of goods.

    Naturally, one person's spending is another person's income. Taxes are government income, obviously. But the government is not simply another consumer seeking to maximize its own utility by purchasing a basket of goods. The government is capable of planning its expenditures in such way to maximize the health of its economy instead of its own welfare. It could engage in spending designed to pay off in the long term (after the bout of inflation has ended), such as preventative medicine or internal infrastructure. Medical costs tend t be positively related to inflation, so reducing future expenditures in this area would reduce consumer's need to spend money on inflation prone items. Infrastructure investments tend to generate cash flows and capital gains that increase positively with inflation. These sort of projects could allow the government to put off its current spending while preserving the real value of its money.

    Ultimately, this conjecture proves nothing. It stems in neither history nor data. Rather it is intended to raise the discussion of the relationship between taxes and inflation.

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