Inflationary finance, capital mobility, and monetary coordination

Abstract

This paper compares the inflation rate before and after monetary coordination between two benevolent governments. Many authors have previously argued that monetary coordination will reduce inflation [e.g., Aizenman, 1992; Beetsma & Bovenberg, 1998; Jensen, 1997; Kimbrough, 1993; Sibert, 1992; Tori, 1997]. Unlike these studies, the present paper introduces a mobile factor, which is capital. While capital may move freely between countries, it is subject to the inflation tax of the country in which it is located. This is because of a cash-in-advance type constraint governing investment expenditures. Since capital is perfectly mobile, inflation tax competition between governments leads to suboptimally low inflation. When countries coordinate their monetary policies, they can raise the inflation tax simultaneously without fear of capital flight. Hence, inflation tends to increase rather than decrease after monetary coordination. © 2001 Elsevier Science Inc. All rights reserved.