The inflation tax makes available to the monetary authorities real resources for development programmes. And if these resources are used for investment, the inflationary policy may accelerate economic growth.
The amount of resources transferred by the inflation tax is a function of the rate of inflation and the elasticity of demand for real cash balances.
So long as real income is constant, each issue of currency to finance a government budget deficit will raise prices proportionately.
If the government issues Rs.1 crore, the nominal supply of money will rise to Rs 6 crores and there will be a 20% rise in prices.
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This rise in prices will cause the real value of money stock to fall back to Rs. 5 crores and the original stock of money (M/p)0, will now only purchase Rs. 4 crores worth of goods and services.
Thus, the issue of Rs.1 crore worth of new currency serves to take away an equivalent amount of purchasing power from the existing stock. It is as though that the government has confiscated 20% of the existing stock of money, (M/P)0.
The amount of resources transferred by the inflation tax is a function of the rate of inflation and the elasticity of demand for real cash balances.
The level of real cash balances held represents the tax base and the rate of inflation (or the rate of monetary expansion) is the tax rate.
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If the inflation rate is 2% and the money balances are equal to 20% of national income, then 4% of the national income is transferred to the government through inflation tax.
By decreasing the purchasing power of the stock of money balances, inflationary issues of money serve to transfer the lost purchasing power to the government.
It should be noted that during the transitional stages of inflationary development policy, the growth contribution of an inflationary tax may be outweighed by the wastage of resources or the collection cost of such a tax.
Inflation tax may encourage the public to evade the tax by reducing their holdings of money, shortening payment periods, holding inventories of goods instead of cash, etc. All these efforts involve wastage of real resources and a reduction of real income.