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July/August 1994, 
Vol. 76, No. 4
Posted 1994-07-01

The Inflation Tax and the Marginal Welfare Cost in a World of Currency and Deposits

by Alvin L. Marty

Since inflation is the rate at which the purchasing power of money declines, it is a tax on real money balances. Alvin L. Marty provides an analysis that determines the optimal rate of inflation as an efficient tax rate. He explains the government’s revenue and the total cost associated with inflation and how each is affected by the level of the inflation rate. An efficient tax system minimizes the total cost of collecting a given tax revenue. For inflation to be chosen as a component of an efficient tax system, however, the inflation rate must be set so that the marginal cost per dollar of government revenue from inflation is equal to the marginal cost per dollar of other sources of revenue. Marty shows how the analysis of such an optimal rate of inflation is altered when there are two components of money—currency and deposits—one produced directly by the government, or its central bank, and the other provided by a competitive banking system.