Box B: Inflation and public finances

Economists focus on 'real' magnitudes, or those that are measured in a way that removes the effects of inflation. Standard national accounting procedures are designed to capture both real volume measures and 'current price' measures by deflating nominal values by an appropriate price index. However, in the realm of public finances, there has been something of a blind spot when it comes to inflation adjustment and standard statistics do not account for the effect of inflation. At the same time, the impact of inflation can be considerable since the bulk of government liabilities are denominated in nominal terms. There is thus an 'inflation tax' reflected in the reduction in government liabilities in real terms (and corresponding reduction in the real value of the assets of the bond holders). The first attempt to develop a systematic framework to measure this effect was undertaken by two economists at the Bank of England in the late 1970s, Christopher Taylor and Andrew Richard Threadgold. This was at a period of high inflation when the effect of 'inflation adjustment' was considerable: the high inflation that took off in the mid-70s had a major impact on the government finances. In particular, the large government deficits were shown to be much smaller when accounting for the inflation tax effect.