POLITICAL-ECONOMY OF MONETARY AND BUDGETARY POLICY

Even though all debt and wage contracts are indexed, there is an incen tive to levy a surprise inflation tax as this erodes the real value of debt service, permits a cut in the tax rate and boosts private consum ption. With rules it is optimal to smooth tax and seigniorage revenues . However, with discretion (associated with the Markov-perfect equilib rium) the government finances an increase in spending through addition al interest income paid on assets that are generated through a tempora ry bout of inflation and taxation. The electorate prefers to appoint a central banker more concerned with inflation than the median voter.