The effects of monetary indexation on revenues from monetization in Iceland are discussed, and the factors behind the sharp fall in monetization revenues following the introduction of indexation in 1979 are evaluated. The fiscal consequences are then examined, given that revenues from monetization have traditionally made up a substantial part of government revenues in Iceland. Different policy options are simulated using as a framework the public finance approach to inflation. The simulations focus on the relation of fiscal deficits to inflation, output, growth, and internal and external debt.

Abstract

The effects of monetary indexation on revenues from monetization in Iceland are discussed, and the factors behind the sharp fall in monetization revenues following the introduction of indexation in 1979 are evaluated. The fiscal consequences are then examined, given that revenues from monetization have traditionally made up a substantial part of government revenues in Iceland. Different policy options are simulated using as a framework the public finance approach to inflation. The simulations focus on the relation of fiscal deficits to inflation, output, growth, and internal and external debt.

With the passage of the Economic Management Act in 1979, Iceland introduced a comprehensive system of monetary indexation. Bank deposits and loans were linked to price developments, while the Central Bank of Iceland indexed the corresponding portion of required reserves. Indexation had important effects on the revenue derived from money creation, a revenue source on which the Icelandic authorities had relied heavily. With a substantial part of base money now being insulated, the Government’s ability to derive revenues by responding to the inflation-induced demand for base money diminished. The tax base on which the inflation tax could be levied shrank substantially, as currency in circulation remained the only part of base money that was an interest-free liability of the public sector, and which could cover real expenditure through the issue of nominal liabilities. However, as a result of the indexation of financial assets in the banking sector, real interest rates increased significantly. With relatively higher opportunity costs of holding cash, the demand for currency decreased, thus further diminishing the inflation tax base.

The greater willingness of the public to absorb broad money and the subsequent increase in financial savings in the domestic economy did, however, translate into more seigniorage for the authorities. But since the inflation tax effect exceeded the seigniorage effect, total revenues from money creation declined.

This decrease in monetization revenues had important consequences for fiscal policy, which will be studied in greater detail in the framework of the public finance approach to inflation. Although, in principle, monetary indexation can affect the economy in various ways,1 the analysis will be carried out under restrictive assumptions. For example, the implication that monetary indexation might have for the government’s costs of nonbank borrowing—which could well aggravate the fiscal deficit—will be ignored. The offset provided by the possible increase in profits in the banking sector resulting from higher yields on required reserves, which leads to higher income tax revenues, will also be ignored.2

These limitations should be kept in mind, especially with regard to the policy simulations presented in this paper. The simulations are preceded by a description of the evolution of monetary indexation and of the present situation in Section I. Section II discusses the measurement of revenues from money creation. The analytical framework is presented in Section III. Section IV provides empirical results on the effects of indexation on the demand for money. Section V presents some policy simulations, and Section VI contains the conclusions.

I. Evolution of Monetary Indexation in Iceland

Monetary indexation in its present comprehensive form was institutionalized by the Economic Management Act of 1979, although there had been some earlier moves in this direction.3 In fact, the origins date from the mid-1970s when a policy of raising the cost of credit and revenues from monetary assets was introduced. In 1976 special interest premium accounts—with interest premiums to be regularly considered in view of price developments—were initiated, and since 1977, a price compensation factor based on the cost of living and building cost indices has been added to bank lending and deposit rates. However, because these arrangements provided for only partial ad hoc adjustments of interest rates to inflation, which started to accelerate at the end of 1977, bank deposits continued to fall in relation to gross domestic product (GDP), while the demand for credit rose unabated.

In order to lessen the disincentives to save associated with negative real interest rates, the Government announced a system of general price indexation of savings and credit in April 1979 to be implemented before the end of 1980. Whereas earlier legislation explicitly prohibited the general use of indexation, the Economic Management Act of 1979 provided for full and automatic adjustment of interest rates to inflation.

The first steps toward positive real interest rates were taken during the remainder of 1979 when nominal interest rates were raised three times. Banks were given permission to grant fully indexed loans carrying a positive real rate of interest, with the loan principal indexed to the credit terms index.4 The minimum loan maturity was initially set at four years, shortened to two-and-one-half years in early 1981, and to six months in 1983. The real interest rate on indexed loans was initially set at 2½ percent. On the deposit side, banks began to offer fully indexed two-year time deposits carrying a real interest rate of 1 percent in 1980, and in 1981 the minimum maturity was reduced to six months. Three-month indexed deposits with a zero real interest rate were also made available in 1982.

Real interest rates were initially set by the Central Bank (as were the nominal rates on nonindexed instruments), but since 1984, market forces have been given an increasing role in interest rate determination. To maintain competitiveness, the banks introduced “switching-term deposits” in 1984; these were deposits whose terms switched between ordinary and indexed rates according to which was more favorable to the depositor. The Central Bank Act of 1986 left commercial banks free to set practically all their own interest rates. The deregulation of interest rates caused deposit and lending rates to rise, as banks increasingly competed among themselves and with other institutions for financial savings (Figure 1). The ratio of total deposits to GDP increased considerably in response to higher real interest rates, with switching-term deposits proving particularly popular (Figure 2).

Overall, indexation has had predictable effects, as depositors have responded to the more favorable terms by increasing their financial savings.5 Index-linked borrowing has also gained in popularity. At end-1988, 56 percent of all bank deposits were linked to the credit terms index, 7 percent were linked to foreign exchange,6 and 37 percent were nonindexed. On the credit side, 35 percent of bank loans were linked to the credit terms index, and about 31 percent were linked to foreign exchange, leaving about 34 percent nonindexed. For the financial system as a whole, only about 15 percent of loans were nonindexed. Moreover, almost all treasury bonds were indexed, as were most private sector bonds.

Since 1988, however, the Government has attempted to reduce financial indexation. In July 1988 it banned direct indexation of the principal value of financial instruments with maturities shorter than two years, and set the minimum maturity for indexed bank deposits at six months. In June 1989 the Central Bank announced that indexation of switching-term deposits would only apply to the unused amount in each savings account in each six-month period.

When indexed time deposits were introduced, similar accounts were opened in the Central Bank for required reserves of deposit money banks. Although originally only the portion of required reserves corresponding to the banks’ indexed deposits was indexed,7 in February 1987 it was decided to index all required reserves at a zero real rate of interest.8 However, since March 1988, required reserves have earned a real interest rate of 2 percent.9

Figure 1.
Figure 1.

Deposits in Deposit Money Banks

(In percent)

Citation: IMF Staff Papers 1990, 004; 10.5089/9781451930788.024.A005

a In percent of total deposits.b Switching-term deposits, introduced in 1984, are deposits whose terms switch between ordinary and indexed rates according to which is more favorable to the depositor.c End-of-June data.Source: Information provided by the Icelandic authorities.
Figure 2.
Figure 2.

Real Interest Rates

(In percent)

Citation: IMF Staff Papers 1990, 004; 10.5089/9781451930788.024.A005

Source: Central Bank of Iceland, Economic Statistics Quarterly.Note: Data points for 1972–79 refer to annual series; 1980–89 data points are quarterly.a Deflated by the change in the credit terms index during the past 12 months.

II. Measurement of Revenues from Money Creation

Domestic financial savings have increased as a result of the monetary indexation.10 If required reserves, which have correspondingly increased, had not been indexed, revenues from money creation would have been larger than they have been. In the steady state, these revenues are equal to (g +π)m, where g denotes the growth rate of real income (assuming unitary income elasticity), π denotes the inflation rate, and m denotes real base money. Whereas gm can be interpreted as seigniorage—that is, the steady-state increase in the real value of base money—πm represents the inflation tax—that is, the amount of nominal balances that needs to be accumulated just to keep the real value of base money constant (Anand and van Wijnbergen (1988, 1989)).

Assuming that the Central Bank pays no interest on its liabilities and issues monetary assets at a rate equal to the inflation rate, it taxes money holders (the deposit money banks which pass the loss on to their depositors) at that rate (Fischer (1982)).11 However, in the case of Iceland this assumption cannot be maintained. As noted above, all required reserves earned interest before 1979, but after the introduction of indexation that portion of required reserves corresponding to the indexed deposits of deposit money banks was also indexed.12 From February 1987 to February 1988, all required reserves were fully indexed but received zero real interest. Since March 1988, real interest of 2 percent has been paid. Taking this into account, it appears more appropriate to use the following measure of revenues from money creation (RM).13

RM=[g+ϕπ+(1ϕ)(πi)]m.(1)

Equation (1) follows an approach suggested by the Organization for Economic Cooperation and Development (OECD) (1988, p. 65), in which revenues from money creation in Iceland were calculated by the (negative of the) real interest rate paid by the Central Bank— (i - π)m. This approach does not take into account that interest is paid only on a fraction of base money—namely, required reserves (1 - φ)m—whereas currency in circulation, φm, is an interest-free liability of the Central Bank.

Calculations show that revenues from money creation have substantially decreased during the period of indexation. According to Table 1, average annual revenues were 2.96 percent of GDP in the preindexation period from 1971 to 1980, whereas in the period from 1981 to 1987 the average revenue was 1.49 percent.

There are several reasons for this decline, the most important being the move to nonnegative real interest rates on required reserves. As discussed, most base money in Iceland is not an interest-free liability of the Central Bank. Although in the 1970s interest was paid on required reserves at a rate equivalent to the interest rate paid by the deposit money banks on deposits plus a certain premium, the real interest rate on required reserves was still negative. To the extent that the inflation rate exceeded the nominal interest rate, the Central Bank received inflation tax revenues (in addition to revenues arising from the issue of bank notes and coins). When indexation was introduced, however, the portion of required reserves corresponding to the indexed deposits of deposit money banks was also linked. Thus, the base on which the inflation tax could be levied shrank, irrespective of the increase in deposits of the deposit money banks and, hence, in required reserves. When it was decided in February 1987 to index ali required reserves, currency in circulation and free reserves (which have traditionally been small) remained the only sources of inflation tax revenues.

Table 1.

Selected Sources of Government Revenues

(In percent of GDP)

article image
Source: Staff calculations.

When indexed deposits were introduced, the opportunity cost of holding cash rose. While financial savings in bank deposits increased, currency in circulation (in relation to GDP) declined from 2.17 percent in the period from 1972 to 1980 to 1.25 percent in the period 1981 to 1987. This substitution effect also diminished the inflation tax base, leading to a decline in revenues from monetization.

Two further effects should be mentioned. One is the reduction of the (average) reserve requirement ratio by 10 percentage points in April 1985 and by 5 percentage points in March 1987 (Table 2).14 The other noteworthy effect was the deregulation of interest rates in the 1980s. To the extent that increasing interest rates on deposits in deposit money banks also led to higher interest rates on required reserves and, hence, to a smaller gap between nominal interest rates and the rate of inflation, the deregulation contributed to the decline of revenues from money creation.

As a consequence of this decrease in revenues from monetization, total government revenues have been smaller than they otherwise would have been. Such a diminution requires a cut in the deficit to keep the public debt from rising (Dornbusch (1988, p. 12)).

III. Money Creation and the Public Finance Approach

In this section, an analytical framework is presented in which the effects from decreased revenues from money creation can be studied in greater detail. The analysis uses the public finance approach to inflation, which was developed by Phelps (1973), Dornbusch (1977), Buiter (1983), and Drazen and Helpman (1987). Without denying that, in the short run, demand pressures or cost-push factors may be more important determinants of inflation, this approach argues that the ultimate reason for the existence of high inflation rates lies in the government’s need for revenues. As Anand and van Wijnbergen (1988, 1989) have shown, the public finance approach provides a useful apparatus for evaluating the implications for fiscal policies of financial sector reforms. Although Anand and van Wijnbergen (1988) focused on changes in bank deposit rates, their model can easily be adjusted to take account of the effects of monetary indexation.

Table 2.

Monetary Indicators

(Annual changes; in percent)

article image
Source: Central Bank of Iceland, Economic Statistics Quarterly (various issues).

In 1971 the reserve requirement was 20 percent of all deposits in commercial banks.

Until February 1989 the credit terms index was composed of the cost of living index (two thirds) and the building cost index (one third). At present, the cost of living index, the building cost index, and the wage index have a weight of one third each.

In order to derive the fiscal consequences of monetary indexation, start from the following public sector deficit identity:

D+iB+i*B*E=ΔB+ΔB*E+ΔDCG.(2)

The left-hand side of equation (2) shows expenses of the public sector (net of tax revenues or transfers from the central bank):15 the noninterest deficit D, plus nominal interest payments on domestic and foreign debt. The variable i(i*) is the nominal domestic (foreign) interest rate on domestic (foreign) debt B(B*), and E is the nominal exchange rate. On the right-hand side are the financing items; that is, the issue of domestic or foreign debt plus central bank advances to the public sector.

Since the government can shift a part of its deficit into the central bank accounts by simple bookkeeping changes and central bank credit to the government represents a claim of one public entity on another, the debt of intergovernmental agencies can be consolidated (Robinson and Stella (1988)). According to equations (3) and (4) derived from a simplified central bank balance sheet

M=DCG+NFA*ENW(3)
M=Cu+RR,(4)

base money is equal to currency in circulation (Cu), plus required reserves held by the deposit money banks at the central bank. Base money is issued to cover credit to the government and the central bank’s accumulation of net foreign assets (NFA*E), insofar as these are not already covered by the central bank’s accumulated profits of net worth (NW).16 Subtracting the central bank’s profits (interest earnings on foreign reserves) from the budget deficit and the counterpart of the central bank profit; that is, subtracting the increase in net worth from the public sector’s increase in liabilities yields

D+iB+i*(B*NFA*)E=ΔB+ΔB*E+ΔDCLGΔNW.(5)

Consolidating the change in the central bank’s net foreign assets and the change in the government’s foreign debt yields

D+iB+i*(B*NFA*)E=ΔB+(ΔB*ΔNFA*)E+ΔM.(6)

Taking into account that exchange rate changes imply capital losses or gains, which are part of the cost of servicing foreign debt, and deflating all variables, equation (7) can be reformulated as follows:

d+rb+(r*+Δe/e)(b*nfa*)e=Δb+Δ[(b*nfa*)e]+Δm,(7)

where lowercase letters now denote real variables.

According to equation (7), the fiscal deficit, including the central bank’s profit-and-loss account, but only counting real interest payments, equals changes in the real value of domestic and foreign debt and base money. If no nominal interest is paid on required reserves. Δm represents the government’s revenues from money creation, which is equal to (g + π)m in the steady state. Since this assumption cannot be maintained in the case of Iceland, Δm has to be replaced by equation (1).

In order to evaluate different policy options, it is important to know how the demand for money responds to changes in inflation and economic growth and whether these reactions are different if monetary assets are indexed. In order to separate effects on the demand for currency (C) and for deposits (D), the following partial-adjustment money demand functions will be estimated:17

log(Ct/Pt)=α1+α2log(Ytr)+α3(it)+α4(πt)+α5log(Ct1/Pt1)+(8a)
log(Dt/Pt)=α6+α7log(Ytr)+α8(it)+α9(πt)+α10log(Dt1/Pt1)+,(8b)

where P is the GDP deflator of period (t); Yr denotes real GDP; i is a weighted average of interest rates on demand, time, and savings deposits; π is the inflation rate; and ∈ is an error term.

Finally, it seems reasonable to assume that the alternative sources of budget deficit financing are subject to certain limitations. Here, a particularly simple debt strategy is supposed; that is, fixed debt/GDP ratios for both internal and external debt.18 Target values for these ratios imply that real domestic debt cannot grow faster than real output19 and real foreign debt cannot grow faster than the product of output times the real exchange rate:

b=nb(9a)
(b*nfa*)e=(nΔe/e)(b*nfa*).(9b)

Inserting equations (9a) and (9b) in (6) yields (expressed as a percentage of GDP):

[d+rb+r*(b*nfa*)e]/GDP=[nb+(nΔe/e)(b*nfa*)]/GDP+Δm/GDP.(10)

According to equation (10), the noninterest deficit plus real interest payments on domestic and foreign debt cannot exceed what can be financed through debt issue at the targeted debt/output ratio, plus the revenue from (steady-state) money creation.

IV. The Demand for Money: Empirical Results

Using quarterly data,20 the partial adjustment model given in equations (8a) and (8b) was estimated for the preindexation period 1972:2 to 1980:2. The regressions produced reasonable results, which are reported in Table 3.21

As far as the demand for cash is concerned, all coefficients have the expected sign and are significantly different from zero, at least at the 10 percent level. All the diagnostic tests are satisfied at a significance level of 5 percent; neither residual autocorrelation, nor nonnormality nor heteroscedasticity can be detected. Similarly satisfying results were obtained for the demand for deposits. Again, all coefficients show the expected sign, while the t-values indicate a strong significance especially for real income and the inflation rate.

Table 3.

Regression Results

article image
Source: Staff calculations.Note: The figures in parentheses below the coefficients are (-statistics; R2 is the coefficient of determination; DW is the Durbin-Watson statistic; one asterisk indicates that the coefficient is significantly different from zero at the 10 percent level, two asterisks indicate significance at the 5 percent level and three asterisks at the 1 percent level.

Lagrange multiplier test for autoregression conditional heteroscedasticity; the probability value of the test statistic under the null hypothesis is shown in parentheses.

Lagrange multiplier test for residual autocorrelation; the probability of the test statistic under the null hypothesis is shown in parentheses; according to further tests, the hypothesis of the nonexistence of residual autocorrelation of different orders could not be rejected.

χ2 -test for normal distribution of residuals; critical values at the 5 percent level in parentheses.

In order to evaluate the out-of-sample properties of the model, the estimations were used to forecast the demand for currency and deposits in the 1980s. The predicative accuracy was poor. Assuming that the model has been correctly specified, the predicative failure for the equations indicates that there has been a structural break in the demand for money.22 In fact, the Chow test for parameter constancy rejected the hypothesis of parameter stability.23 The χ2-test24 was applied, which confirmed the results of the Chow test. As can be seen from Figure 3, the regression for the demand for currency implies a serious overestimation of actual developments in the indexation period, whereas the demand for deposits is heavily underestimated. This indicates that the introduction of monetary indexation has caused a significant shift in portfolio preferences.

Re-estimating the model for the indexation period 1980:4 to 1987:4 produced the results also reported in Table 3. Almost all of the coefficients are highly significant and all of them have the correct sign. The diagnostic tests do not indicate that the regressions suffer from residual autocorrelation, nonnormality, or heteroscedasticity. Two points are worth noting: first, the interest rate variable that was used for the estimation of the demand for money in the preindexation period proved to be no longer significant. However, for demand for deposits, the indexed interest rate had a strong influence on time deposits.25 In contrast, the opportunity costs of holding currency seem to be solely determined by the rate of inflation, whereas the return on alternative assets no longer appears to play a significant role. Experiments with different interest rates did not meet with success, so the interest variable was omitted. Second, on the one hand, the (semi-) elasticity of the demand for money with respect to inflation decreased significantly, both in the case of the demand for currency and for deposits. On the other hand, the elasticity with respect to real income increased considerably, especially for demand for currency.

Figure 3.
Figure 3.

Demand for Money: Actual and Fitted Values

(In logs)

Citation: IMF Staff Papers 1990, 004; 10.5089/9781451930788.024.A005

Source: Staff calculations.Note: In real terms (deflated by the GDP deflator).

These regression results will now be used to estimate the demand for money and, hence, the revenues from money creation with and without indexation. This is done under alternative macroeconomic scenarios in order to evaluate different policy options.

V. Some Policy Simulations

Because indexation of base money leads to lower revenues from money creation, the so-called financiable deficit—that is, the deficit that can be financed without jeopardizing target values for internal and external debt—becomes smaller. If the government decides not to adjust fiscal policies and, hence, the actual deficit, by cutting expenditures or raising taxes, then those targets will not be attainable.

Since monetary indexation leads to a smaller base on which the inflation tax can be levied, one obvious possibility is to increase the tax rate; that is, the inflation rate. In order to evaluate this option in greater detail, let us suppose that in the indexation scenario all required reserves are fully indexed, whereas in the nonindexation scenario required reserves do not even earn interest. These assumptions, while somewhat unrealistic, help highlight the implications of indexing base money.

Under those assumptions a policy of raising inflation rates would have the following outcomes in 1985 (Table 4).26 With money demand relatively inelastic to the opportunity cost of holding money, increased inflation generates increased revenues from monetization.27 However, the marginal increase in revenues gradually falls as inflation rises because the demand for real balances falls.28 Under indexation, an inflation rate of even 100 percent would cause revenues from money creation of only 1.4 percent of GDP.29 In contrast, in the nonindexation scenario where base money is an interest-free liability of the central bank, revenues from money creation achieve this level at an inflation rate of only 30 percent. At an inflation rate of 100 percent, total revenues are more than two-and-one-half times larger than in the case of indexation. This difference would of course be even larger if required reserves received a positive real rate of interest, as has actually been the case since March 1988.

Table 4.

Revenues from Money Creation at Alternative Inflation Rates

(In percent of GDP)

article image
Source: Staff calculations.

Revenues from money creation are only one source of financing. In addition, there is domestic debt issue and foreign borrowing.30 In order to estimate the financiable deficit, all three sources have to be combined. Thus calculated, the financiable deficit can then be compared with the actual deficit, with the difference between the two measures indicating the required deficit reduction.31 This has been done in Table 5 whereby the analysis focuses not only on changes in the inflation rate, but also on changes in economic growth and the real exchange rate.

Table 5.

Required Deficit Reductions for Consistency with Various Macroeconomic Targets

(In percent of GDP)

article image
Source: Staff calculations.

As Table 5 shows, required deficit reductions are considerably higher in the case of indexation. Assuming that real economic growth is 3 percent and that the real exchange rate does not depreciate, fiscal adjustment would still be necessary at an inflation rate of even 30 percent. In contrast, if required reserves are not indexed, the financiable deficit would be equal to the actual deficit at an inflation rate of only slightly more than 10 percent. However, if economic growth accelerates, the need for fiscal adjustment decreases. At a growth rate of 4 percent, the financiable deficit exceeds the actual deficit even in the case of indexation (under the assumption that the inflation rate is only 10 percent). In turn, the need for fiscal adjustment increases if economic growth decelerates, with the required deficit reduction being relatively greater in the case of indexation.32

For the Icelandic economy, which is subject to severe shocks from its heavy reliance on fisheries, these results are of great interest. Suppose, for example, that as a result of an exogenous shock there is a decline in the rate of economic growth. Such a decline will, other things being equal, necessitate a compensating increase in the steady-state rate of inflation in order to keep the Government’s revenues from money creation unaffected. The required increase in the rate of inflation is, however, substantially larger in the case of indexation than nonindexation. As has been shown by Melnick and Sokoler (1984), a decline in the growth rate may not only call for an increase in the rate of inflation (an increase greater than the decline in the rate of growth), but may also imply that the necessary compensating increase in the rate of inflation is a positive function of the existing rate of inflation. This will be the case if the demand for real balances is a semilogarithmic function of the expected rate of inflation, or, in other words, if the elasticity of the demand for money with respect to the expected rate of inflation increases as the rate of inflation rises.33

In order to prevent a deceleration of economic growth, the authorities might pursue an export strategy that relied on real exchange rate depreciation. However, such a policy would imply a greater need for fiscal adjustment by raising the ratio of foreign debt to GDP. Because of Iceland’s high external debt, the required deficit reduction increases remarkably with the rate of real depreciation. Assuming real economic growth of 3 percent and an inflation rate of 10 percent, real depreciation of 4 percent would cause a gap of 1.8 percent of GDP between the financiable deficit and the actual deficit, even in the case of nonindexation. If required reserves are fully indexed, the necessary fiscal adjustment would be even larger.

Further simulations are conceivable, for example, to explore the consequences of changes in reserve requirements34 or in bank interest rates (see, for example, van Wijnbergen (1985)). However, it should already be clear that monetary indexation has important budgetary implications.

VI. Conclusions

As has been shown in this paper, monetary indexation has significant budgetary consequences that are all the more important for countries like Iceland, where revenues from money creation represent a substantial part of total government revenues. Starting from the observation that revenues from money creation declined sharply after indexation was introduced, a simple framework was presented in which the consistency of fiscal deficits with other macroeconomic targets could be assessed. This framework, based on the public finance approach to inflation, made it possible to consider the relations of fiscal deficits to other targets including output growth, real exchange rate developments, and internal and external debt, with and without indexation. By simulating different policy options it can be shown that, other things being equal, monetary indexation considerably raised the need for fiscal adjustment.

This would not have been the case if only financial assets in the banking system were indexed. On the contrary, due to the increase in seigniorage associated with larger bank deposits and required reserves, required deficit reductions would have been comparatively lower. However, in the absence of base money indexation the spread between deposit and lending rates would probably increase significantly.

Recently, the Icelandic authorities have taken steps to reduce the extent of monetary indexation. As an alternative to linking monetary assets to price developments, deposits have been introduced with assets linked to the exchange rate. These schemes may provide an alternative not only to deposits indexed to the credit terms index but also to foreign exchange deposits. Although foreign exchange-linked deposits do not require the use of actual foreign currency, foreign exchange deposits normally lower the base on which the inflation tax can be levied—insofar as they provide a liquid alternative to domestic money.35 However, in Iceland foreign currency deposits are nevertheless subject to reserve requirements, so that this potential effect is of no importance.36

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*

Peter K. Cornelius is an Economist in the Exchange and Trade Relations Department. When this paper was written, he was in the Northern European Division of the European Department. The author, who received his doctorate from the University of Göttingen, is grateful to Richard K. Abrams, Mario t. Blejer, Adalbert Kröbl, Duncan M. Ripley. David J. Robinson, and Hans O. Schmitt for many helpful comments. Some of the data were kindly provided by I. Fridriksson of the Central Bank of Iceland.

1

See, for example, Baer and Beckerman (1980), Kapur (1982), and World Bank (1989, pp. 63–68).

2

The income tax effect also depends on whether the tax system includes corrective mechanisms for inflation. See Tanzi (1976, 1989, pp. 647–51). For a description of the Icelandic tax system, see Kolbeinsson (1982) and Organization for Economic Cooperation and Development (1988).

4

Originally, the credit terms index was calculated monthly on the basis of the cost of living index (with a weight of two thirds) and the building cost index (one third). In February 1989 the composition of the index was changed; the wage index was added with a weight of one third, and the weight of the cost of living index was reduced to one third.

5

The deregulation of interest rates also contributed to this development.

6

In 1987 the Government considered using the exchange rate as an element in the credit terms index, but decided against it. Instead, exchange rate-based indexation has been authorized, allowing financial assets to be linked either to the credit terms index or to the SDR or the European Currency Unit (ECU).

7

However, all required reserves earned interest.

8

The indexation adjustments are included in reserve money at the end of each month, but the banks have access to the funds only at the end of the year.

9

The decision to pay real interest on required reserves was made in December 1988 to facilitate a reduction of interest rates in deposit money banks. This change was made retroactive to March 1988.

10

For an overview of other reforms see Nordal (1988) and various issues of the Annual Report of the Central Bank of Iceland.

11

With positive real interest rates on deposits and negative yields on required reserves, the spread between deposit and lending rates would be considerable.

12

Interest was paid on the nonindexed portion of required reserves corresponding to the nonindexed deposits of deposit money banks.

13

For a discussion of alternative measures of revenues from monetization, see Barro (1982) and Gros (1989).

14

In the 1970s the (average) reserve requirement ratio was gradually raised from 20 percent to 28 percent, where it remained until April 1985. More recently, the ratio was further lowered by 1 percentage point in August 1988 and again in April 1989.

15

As mentioned above, tax revenues and other budgetary items are likely to be affected by monetary indexation.

16
For simplicity, excess reserves, which are of secondary importance, are ignored, as is the fact that the central bank not only holds reserves from deposit money banks but also lends to them as well as to other private agents. Strictly speaking, the monetary base would have to be adjusted as follows:
MAdj=(CuDCPVT)+(RRDCCML),(4)
where DCpVT and DCcml denote central bank credit to other private agents and to deposit money banks, respectively.
17

Analysis of government revenue from monetary expansion frequently postulates an aggregate demand function for fiat money. Rarely is it recognized in these formulations thar the demand for fiat money is composed of two distinct components: a direct demand for currency and an indirect demand for bank reserves derived from the public’s demand for deposits and reserve requirements. However, in order to explore how bank regulations, especially reserve requirements, affect revenues from money creation, it seems more appropriate to estimate the two components of base money separately. See Fry (1981), Siegel (1981), and Anand and van Wijnbergen (1988).

18

As a matter of course, more sophisticated debt strategies could be implemented. As far as external debt is concerned, a weighted average of the debt/ output ratio and the debt/export ratio, for example, might be more appropriate. See Cohen (1988).

19

If government debt were not indexed—contrary to the actual situation in Iceland—an increase in the inflation rate would lead, under certain circumstances, not only to higher revenues from money creation, but also to a liquidation of outstanding debt. See Calvo (1989).

20

Since quarterly data for GDP are not available for Iceland, annual data had to be interpolated. Moreover, seasonal dummies were included, but the results are not reported here.

21

These results are similar to those obtained by Eggertsson (1982), who, however, used an aggregate demand function.

22

A structural break in the demand for broad money was detected by Rodlauer (1984).

23

For the demand for currency, the Chow-test value (31,27) was 2.73; for demand for deposits, the value was 1.67.

24

The χ2-test of whether the model parameters remain constant in the forecast period is calculated as χ2 (N)N, which yields an approximate F-test. The test values significantly exceeded the critical value of 2 (for demand for currency, the value was 9.07; for demand for deposits, the value was 144.68). For the methodology, see Hendry (1989).

25

In the regression, the implicit nominal return was used.

26

The year 1985 seems particularly appropriate, since variables like GDP growth, inflation, and the budget deficit did not show the extreme values as in other years when external shocks took place; 1985 can thus be regarded as an “average” year.

27

For dynamic considerations, see Auernheimer (1974).

28

If the actual rate of inflation is higher than the rate at which revenues reach their maximum, an effective money demand-increasing policy might allow the government to maintain the size of its present budget deficit while reducing inflation. The policy problem, however, is to find the combination of expectations-changing policies sufficient to create the jump from the “high-inflation trap” where real money demand is lower to the “efficiently” financed deficit where money holdings are higher (Blejer and Cheasty (1988, p. 870)). It should be stressed that the inflation rate where revenues from money creation are maximized must not be interpreted as the “optimal” inflation rate. From the perspective of the theory of optimal taxation, the optimal inflation tax rate equates the marginal cost of distortions per currency unit of revenue from the inflation tax and from other distorting taxes. See, for example, Mankiw (1987) and Grilli (1989). Recent empirical studies have cast some doubt that from this point of view a positive inflation rate can be justified. See Garfinkel (1989, p. 10).

29

Bomberger and Makinen (1980) have argued that in the case of Hungary indexation of financial assets was mainly responsible for the hyperinflation in 1945–46. Since index linking reduced substantially the tax base on which the inflation tax could be levied, higher inflation rates were needed to derive a given amount of revenues from money creation.

30

See Section III; domestic debt issue and foreign borrowing are calculated in the following under the assumption of fixed debt/output ratios.

31

Because of the lack of consolidated data the actual deficit refers to the so-called A budget of the government, which covers only the Treasury relatively narrowly defined. To take into account revaluations of indexed debt, monetary corrections have been made for accruals from those revaluations. See Tanzi, Blejer, and Teijeiro (1987, pp. 727–29). Thus defined, the actual deficit was 5 percent in 1985.

32

It should be noted that the sensitivity of required deficit reductions with respect to economic growth critically depends on the assumed debt strategy. One might argue that fixed debt/output ratios as assumed here are too restrictive, at least on an annual basis, and that in the light of the supply shocks that periodically hit the Icelandic economy, which relies heavily on its fisheries, a medium-term strategy would seem to be more appropriate. However, the difficulty with this option is that variations in the fish catch are irregular in their amplitude and timing. Therefore, it is not possible to know how much can safely be borrowed in the slump without first knowing how much can be repaid in the boom that follows. In light of Iceland’s foreign debt, which has already reached critically high levels, one could also argue that foreign debt (in relation to GDP) should decrease in any case. This would be the case, for example, if the absolute level is held constant despite an acceleration in economic growth. However, the required deficit reductions would then be higher than reported in Table 5.

33

Such a function, proposed by Cagan (1956), is normally used when the demand for money is studied in countries that experienced high rates of inflation. See, for example, Leiderman and Marom (1988). If, however, the elasticity of the demand for money with respect to the expected rate of inflation is constant— that is, if demand for money is a linear logarithmic function of the expected rate of inflation—then the required compensating increase in the rate of inflation is a decreasing function of the existing rate of inflation.

34

In principle, reserve requirements serve to control the means of payments in the economy and to secure stability in the aggregate price level, but if carried too far, they may become self-defeating as an instrument of monetary control and could seriously interfere with the banking system’s intermediary role in allocating the economy’s scarce resources (McKinnon (1980, p. 106)). As Eggertsson (1989) argues, Iceland has drastically reduced reserve requirements exactly for this reason. As mentioned earlier, this reduction in reserve requirements has also contributed to a decline in monetization revenues.

35

If the rate of interest on domestic currency deposits falls below the (expected) total rate of return from foreign currency holdings (including exchange rate changes), people may satisfy at least some of their demand-for-money requirements by holding foreign currency. Apart from the fact that interest rate-induced currency substitutions may weaken monetary control, a reduction in the real stock of domestic money will, in principle, reduce the level of real revenues that the government can raise through deficit financing and money creation. See Tanzi and Blejer (1982, p. 783).

36

However, insofar as foreign currency accounts may encourage currency substitutions, they can affect the optimal inflation tax. See Végh (1989).

IMF Staff papers: Volume 37 No. 4
Author: International Monetary Fund. Research Dept.