The Credit‐channel Transmission Mechanism and the Nonlinear Growth and Welfare Effects of Inflation and Taxes

Abstract

With the credit‐channel effect driven by the central bank's open market operations, this paper's model easily gives rise to the nonlinear inflation‐growth nexus, which is evidenced by a number of cross‐country empirical studies. The threshold level of the inflation rate is found to be lower when tax rates are higher. The presence of the credit‐channel effect also provides the rationale for setting positive (and smaller than 1) tax rates on consumption, labor income, and capital income. The optimal tax rates rise as the inflation target declines. Under a fiscal policy rule where labor and capital income taxes move proportionally to each other, the optimal capital income tax rate could be higher than the optimal labor income tax rate. Under a sufficiently large central bank balance sheet, the credit‐channel effect will be so weak that inflation and all kinds of taxes are growth and welfare repressing. This provides a rationale for central banks that have implemented quantitative easing policies to shrink their balance sheets. (JEL E58, E62, O42)

Banks' Wealth, Banks Creation of Money, and Central Banking

“…In ‡ation reduces the real value of banks'liability to the CB and thus slacks their borrowing constraint giving them room to increase lending. 5 While the QE induces in ‡ation in the event of the negative shock, it induces de ‡ation in the event of the positive shock. This result might partly explain the aforementioned observation that in some economies the QE causes a great monetary expansion on the one hand and is companied with or followed by lingering low in ‡ation or even de ‡ation pressure on the other hand, which is a puzzle if considered from the point of view of 4 In the model economy, this fact is straightforward because banks use corn, the real good, to redeem their liability.…”

“…For more discussion, see the remark on pages 28-9, Section 5. 5 The point that monetary policy can help banks by a¤ecting the real value of their liabilities is also considered by Diamond and Rajan (2006). Also, the way in which …at money circulates in the model economy is also in Allen and Gale (1998 The rest of the paper is organized as follows.…”