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This article studies the effects of political institutions on inflation. In our view, hyperinflation is the manifestation of a tragedy of commons in a divided society with a weak central monetary authority. Economies with fiat money are inherently inflation-prone: the collection of seigniorage through the inflation tax is less conspicuous than other taxes, and the printing of money is essentially costless. In many countries, the control of the money supply is de facto or de jure decentralized. Sets of agents (in various regions or interest groups) can effectively pressure the central government to finance their expenditures. As these interest groups pursue their self-interest, they neglect the welfare effects of the inflation tax on individuals in other groups. These elements combine to imply that countries which rely on the inflation tax to meet the resource demands of competing interest groups will typically experience inefficiently (due to negative spillovers) high inflation.
After developing this view of inflation, we consider institutional designs that can reduce inflation. We argue that the delegation of monetary policy, through either a currency board or dollarization, can serve as a commitment device and thus eliminate the inflation bias created by decentralized monetary policy. We construct a treaty between the dollarized country and the United States so that dollarization is welfare-improving for both parties.
Our research is motivated by recent events in Argentina, Brazil, Ecuador, Russia, and other countries that have considered the delegation of monetary authority to reduce inflation. In various ways, these countries have experienced episodes of inflation which can be traced to the decentralization of monetary policy.
Argentina provides a leading example. Over the past 40 years, its average annual rate of inflation has been relatively high (compared to, say, the U.S. rate). Argentina's annual inflation rate averaged 30.3 percent over the 1963-73 period, rose to 200 percent during 1973-78, and then increased once again to an annual average rate of 380 percent during 1983-87 (Edwards and Tabellini 1990, Table 1). Inflation reached 3,066.3 percent by 1989. We argue that this high inflation experience is connected with the decentralization of monetary policy. World Bank (1990), Aizenman (1998), and Saiegh and Tommasi (1999) provide a detailed discussion of the interactions between Argentina's provinces and central government. Argentina has a decentralized system...