I come finally to the rate of monetary creation. Given that a country
is going to rely on inflation to finance some governmental expenditure,
what’s the proper rate of inflation? The proper rate of money
creation for a developing country depends in the first in-stance
on whether the objective is primarily the health of the economy
or the revenue of the government.
For the health of the economy, in the most abstract sense which
takes minimum account of friction, the optimum would be to have
a price level declining at a rate that would make the risk-free
nominal rate of interest close to zero.
A more pragmatic judgment, allowing for some friction, would regard
as best a roughly stable, or slowly declining price level of final
products which would mean a moderately rising or roughly stable
price of labor.4
For a country like Israel this latter solution will still mean a
rising quantity of money. As I’ve already indicated, that
latter solution would probably mean a quantity of money rising at
an annual rate of something like 15-20 per cent per year for Israel.
Maximum governmental revenue would generally, though not necessarily,
be yielded by a higher rate of monetary growth than is desirable
for economic health. This is a technical question that I have considered
in detail elsewhcre.5 Here I need only say that the most fascinating
conclusion from my detailed analysis is that many developing countries
in fact increase the quantity of money at a faster rate than would
give them the maximum revenue over a long period.
One reason seems to be that the initial yield from a high rate of
monetary growth is always greater than the ultimate yield from that
rate of monetary growth, because until people come to anticipate
the higher rate of monetary growth, they do not economise fully
on cash balances.
Governments, being shortsighted, are led by the short-term gains
to accept lower long-term yields. One very widespread misconception
about economic development is that governments are generally assumed
to be long-sighted, to look a long distance ahead, and to represent
the long-term interest of the country. Nothing could be farther
from the truth. A government’s perspective, especially in
democratic countries, is limited by the period between elections,
and generally it’s even shorter than that. Individuals in
planning their own lives take a much longer view than governments
do in planning the country’s life. As a result, short-sighted
governments, seeing that they can get some more revenue in the short-term,
are inclined to be very inefficient in their use of inflation.