Unstable inflation and seignorage revenues in Latin America : How many times can the government fool people?

In the past 20 years, high and extremely volatile inflation rates in Latin America have generally been associated with unstable monetary policies and the (temporary) use of inflationary revenues to finance fiscal deficits. There seems to be a consensus that high inflation is bad for economic development and growth, so it is unclear why governments have adopted unstable monetary policies they have known to be unsustainable in the long run. This paper argues that Latin America governments have followed unstable monetary policies principally to maximize their inflationary revenues. Explanations based on irrationality or on institutional and political shock are only partially convincing. A government maximizes inflationary revenues by adopting temporary unstable monetary policies because people tend to revise their expectations (slower) faster in periods of (dec-) accelerating inflation as the cost of collecting information (rises) falls compared with other welfare losses. When the rate of inflation is relatively high, a restrictive monetary policy is implemented so people can reconstitute monetary balances. When the inflation rate is low, an expansive monetary policy is adopted to confiscate existing real balances. Governments may appear for some time to succeed in fooling people, by adopting temporary reforms and restoring confidence, but their reputation is damaged when they repeatedly do so. Utlimately, private agents react so quickly and with such sophistication that even small fiscal gaps produce precipitous declines in money demand. Over time, private agents learn to anticipate the relationship between unstable inflation and monetary policy and progressively reduce their real monetary balance. In the end, the optimal inflation rate tends toward its steady-state value, as Friedman found 20 years ago. The author develops a small dynamic model to stylize these facts and applies it to Argentina.Economic Theory&Research,Environmental Economics&Policies,Public Sector Economics&Finance,Inflation,Banks&Banking Reform