Corruption and Seigniorage

• Published date: 01 August 2015
• Author: GARETH D. MYLES,HANA YOUSEFI
• Date: 01 August 2015
• DOI: http://doi.org/10.1111/jpet.12119

CORRUPTION AND SEIGNIORAGE

GARETH D. MYLES

University of Exeter and Institute for Fiscal Studies

HANA YOUSEFI

University of Exeter

Abstract

There is convincing empirical evidence in cross-section data

of a positive correlation between the level of corruption and

the rate of inflation. This paper explores whether this cor-

relation can be a consequence of a government exploiting

seigniorage to compensate for revenue lost to corruption.

We embed corruption within an overlapping generations

economy that has money as the only store of value and

in which the government optimizes the rate of monetary

growth. Three different forms of corruption are modeled,

and it is shown that all three can be positively correlated

with increased inflation.

1. Introduction

Public sector corruption is endemic in many economies and is frequently

cited as a cause of poor economic performance. Corruption hinders the

completion of beneficial transactions and distorts the outcomes of economic

policies. It can also affect the policy choices of governments as they attempt

to counteract the consequences of corruption. Excessive inflation may be

a negative side effect of corruption if the government compensates for lost

revenue by increasing the rate of monetary expansion to exploit seigniorage.

There is convincing empirical evidence from cross-section studies that

inflation and corruption are positively correlated. It has been suggested that

Gareth D. Myles, Department of Economics, University of Exeter, Exeter, EX4 4RJ, United

Kingdom (gdmyles@ex.ac.uk). Hana Yousefi, Department of Economics, University of Ex-

eter, Exeter, EX4 4PU, United Kingdom (h.yousefi@exeter.ac.uk)

We thank Amrita Dhillon, Myrna Wooders, and the participants at the Warwick-Mysore

Workship on Governance and Political Economy. We are also grateful for comments re-

ceived at PET13 in Lisbon and shadow2013 in M¨

unster.

Received January 18, 2014; Accepted February 8, 2014.

C2014 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 17 (4), 2015, pp. 480–503.

480

Corruption and Seigniorage 481

this is a consequence of governments in corrupt economies turning to the

use of seigniorage as a method of raising revenue (Al-Marhubi 2000). This

seems a likely route through which the correlation can arise, but the mecha-

nism at work has not received any theoretical attention. In particular, there

has been no demonstration that an optimizing government will rationally

exploit seigniorage as a response to corruption. The contribution of this pa-

per is an analysis of this issue in a model in which the growth rate of money

supply is chosen by an optimizing government.

A government has two sources of revenue. It can levy taxes on observable

transactions or it can exploit the monopoly it holds over the creation of

fiat money to obtain revenue from seigniorage. If corruption reduces the

revenue that the government can derive from taxation then a motive is

created for the government to turn to seigniorage as an alternative source

of revenue. When seigniorage is exploited, the implied monetary expansion

will increase the rate of inflation. The missing link in this chain of reasoning

to connect corruption with inflation is a demonstration that the government

has a motive to exploit seigniorage in this way. We model a government

that chooses seigniorage to maximize a legitimate objective function and

demonstrate that corruption can increase the chosen level of seigniorage.

This confirms that the positive correlation can emerge in a world in which all

economic agents pursue the standard objective of individual optimization.

The only previous theoretical analysis of the correlation between cor-

ruption and inflation is Bohn (2010). That paper analyzes a monetary policy

game in the spirit of Rogoff (1985) but with corruption affecting the payoff

function of the government. It is therefore a static analysis that models nei-

ther the role of money in the economy nor the dynamic mechanism lying

behind an intertemporal inflationary process. There has been rather more

analysis of the link between corruption and growth. Blackburn, Bose, and

Haque (2010) and Blackburn and Forues-Puccio (2010) show the damaging

effect of corruption on the process of economic development. However, in

common with much of the growth literature, the models analyzed are non-

monetary, so cannot be used to explore the effect of corruption on inflation.

To undertake our analysis, we need to construct a model of the economy

that is explicitly monetary. This requires there to be a role for money in or-

der to explain its use and value, and some motive behind the government’s

choice of money supply. The range of monetary models in the literature in-

cludes money in the utility function, cash in advance, and money as a store of

value. We choose to focus on the latter, and analyze a model in which money

is the only store of value that allows purchasing power to be carried between

periods. We consider an overlapping generations economy with money and

consumption loans. Individuals can use money to transfer purchasing power

between different periods of life. When, on average, individuals wish to hold

money, then money will have value. Seigniorage will increase money supply

and reduce the value of money or, conversely, raise the money-price of the

consumption good. By making the government choice of money growth rate