Milton Friedman and the Genesis of Inflation Tax Analysis
Van Cott, T. Norman, International Advances in Economic Research
Abstract This essay argues that Milton Friedman's initial exposition of the inflation tax on money was flawed. Ironically, the flaw traces to Friedman's attempt to shoehorn the tax into a Keynesian (circa 1936) setting. While the subsequent inflation tax literature has never acknowledged the flaw, it also never utilized a Keynesian setting to exposit the tax.
Keywords Inflation tax on money * Seigniorage * Milton Friedman
Before Milton Friedman (1953) included "Discussion of the Inflationary Gap" in his Essays in Positive Economics, he added seven paragraphs to his 1942 American Economic Review article with the same title. The seven paragraphs corrected, said Friedman, "a serious error of omission." In particular, Friedman had neglected to point out that the tax inflation levies on the equilibrium real money stock can, under certain conditions, close the inflationary gap. Friedman never said, but the inserted paragraphs surely accounted for the article's inclusion in the long-celebrated collection of essays. (1)
Recall that in Keynesian C + I + G diagrammatics, the inflationary gap is the vertical distance between the C + I + G function and the 45[degrees] line at full employment output. That inflation can close the inflationary gap does not mean that inflation eliminates inflation. Not at all. Friedman's point, rather, was that a determinate distribution of national output can accompany a continuous rising price level.
Kleiman (2000) showed that Friedman's 1953 inflation tax insights were actually a rediscovery of the inflation tax concept, Keynes having explained the idea in his 1923 Tract on Monetary Reform. (2) Kleiman convincingly argued, however, that Friedman was unaware of his Keynesian precursor, leaving Friedman's seven paragraphs to mark the genesis of modern inflation tax analysis. The subsequent building blocks in the inflation tax literature all acknowledged the foundational nature of Friedman's 1953 analysis--see, for example, Bailey (1956), Kessel and Alchian (1960) and (1962), Marty (1967) and (1973), Phelps (1965) and (1973), and Barro (1972). Self-referencing does not pack the same punch, but Friedman referenced his 1953 article in his 1971 article.
That Friedman speculated in 1953 that his 1942 omission of the inflation tax owed to "the prevailing Keynesian [circa 1936, not 1923] temper of the times" (p. 253, emphasis added) adds irony to the Keynesian precursor story, irony noted by Kleiman. Lest we become too smug, Van Cott (1981) pointed out that 18 of 25 intermediate macroeconomics textbooks published between 1975 and 1980 omitted any mention of the inflation tax concept. This was 1) more than 20 years after Friedman's seven inserted paragraphs and 2) subsequent to the building block articles noted above. Given the Keynesian orientation of these textbooks, Friedman's comment about a Keynesian mindset making it difficult to think in inflation tax terms has credibility. (3)
Notwithstanding Friedman's Keynesian disavowal, Friedman attempted to cast his 1953 exposition in a Keynesian 45[degrees] framework. In what follows, I direct attention to a never-noted oddity in Friedman's seven paragraphs, an oddity that traces to the strictures of his Keynesian analytical setting. To wit, the government's claim on output in Friedman's analysis rises by less than inflation tax revenue. In effect, Friedman's self-imposed Keynesian straitjacket necessitated him having a portion of inflation tax revenue substitute for existing, debt-financed government expenditures. Absent the fiscal accommodation, an analytical can of worms ensues.
Given the close attention paid to Friedman's work over the years, the lack of attention to this oddity is curious. Indeed, even though Kleiman (2000) chided Friedman for overlooking his Keynesian circa 1923 precursor, he nevertheless characterized the seven paragraphs as illustrating "the author's [Friedman] customary analytic sharpness and clarity" (p. …