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Monetary Capacity

Roberto Bonfatti (), Adam Brzezinski, Kıvanç Karaman and Nuno Palma

No 15299, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Monetary capacity refers to a state's capacity to circulate money that is accepted by the public, whereas fiscal capacity refers to its capacity to tax. In this paper, we show both theoretically and empirically that monetary and fiscal capacity, and by extension, markets and states have a symbiotic relationship. On the theoretical front, we propose a model that establishes that a higher monetary capacity incentivizes the government to invest in the capacity to tax, because monetization eases taxation. Higher fiscal capacity, in turn, increases the public demand for money, because expected inflation is lower. On the empirical front, we find that monetary capacity had a significant and substantial causal impact on fiscal capacity. To identify this impact, we rely on a natural experiment, instrumenting the money stocks of England, France and Spain between 1550 and 1790 by the silver and gold output in the New World. Finally, to put our findings into a long-run perspective, we collect money stock and tax revenue data for European states from antiquity to the modern period, and document the close relationship between the two. These findings indicate that economic and political development cannot be understood independently. They also qualify the theory of the long-run neutrality of money: exogenous changes in money stock can and did have real long-run effects.

Keywords: fiscal capacity; inflation; monetary capacity; monetary non-neutrality; monetization; Quantity Theory of Money; taxation (search for similar items in EconPapers)
JEL-codes: E50 E60 H21 N10 O11 (search for similar items in EconPapers)
Date: 2020-09
New Economics Papers: this item is included in nep-his, nep-mac and nep-mon
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