Reliance, Composition, and Inflation

To pay for their spending, governments use one or more of the following: taxes, sale of debt to the public, and money creation. Taxes and debt issuance are typically under the purview of the treasury (the government’s fiscal side), and money creation is under the control of the central bank (the government’s monetary side). This split seems natural since most central banks are required to maintain price stability and, hence, ought to have complete control over the money supply. In recent years, however, based on the work of Christ (1968) and Sargent and Wallace (1981), economists have noted that a single, forward- looking budget constraint unifies these two government branches. As a direct consequence of this constraint, every fiscal action potentially has a monetary component to it, and vice versa. As such, it becomes hard to pinpoint whether the central bank really has complete control over money creation or whether it is passively creating money at the treasury’s beck and call. If the latter is true, the central bank is severely constrained in performing its task of maintaining price stability. Or is it? This article presents a model in which the central bank retains substantial control over the inflation rate despite being subservient to the treasury in a very precise sense.