w a wijewardena : why inflation tax is an evil? article by mr w a wijewardena, deputy governor of the central bank of sri lanka, published in sunday times on 10 june 2007. * * * a popular folk story talks of a villager making a chance meeting of a demon in the forest and using his craftiness to get the demon to work for him. understandably, the demon being an untiring person proves to be a marvelous worker. his contribution to the villager far exceeds that of even a thousand workers. according to the story, everything is well and good as long as the villager is able to keep the demon under his control. but, on the day the villager loses his grip over the demon, it would set upon the villager and devour him. so, though the villager would have a jolly - good life in the short run, he runs the great risk of losing everything, including his life, in the long run. governments ’ use of inflation as a tax to force - mobilize resources for funding government projects has been equated to the fate of the villager in that folk story. in the short run, a government could forget about all its fiscal problems and enjoy the temporary solace provided by it. but in the long run, when inflation becomes uncontrollable, it will have to sacrifice all its temporary gains. when an initially mild inflation degenerates into an uncontrollable hyper - inflation later, it has been termed as a mass killer. it would destroy the financial infrastructure and, through it, the entire social and economic infrastructure. rebuilding a nation after this massive destruction would be a very painful and tedious challenge for everyone. what is meant by inflation tax? modern governments have been given monopoly power by their respective societies to produce and supply currency with a single objective : maintaining its value to facilitate its use for transactions, use as a store of value and a unit of account. governments are required to attain this objective by responsibly regulating its supply. governments, when performing this task and as a cost - effective measure, have resorted to the habit of issuing paper currency notes and debased metallic coins thereby gaining a unique advantage. that advantage is the ability to produce it at a cost which is simply a fraction of its face value. for instance, a currency note may have a face value of 1000 units of money, but a government does not spend

. how is the inflation tax imposed? governments have appointed either central banks or currency boards as their agents for producing and supplying currency. unlike currency boards which have to maintain a hundred percent reserve of valuable assets ( gold and hard foreign currencies such as dollars, euros or sterling pounds ) for issuing currency, central banks are peculiar animals. they do not have to have a reserve of an equivalent amount and can issue currency simply by making book entries. in other words, they can acquire any asset by assuming a liability on account of the currency they have issued. for instance, if a central bank has to acquire a building, all it has to do is to open its vault and issue the required amount of currency to the seller of the building. after the transaction, the central bank has a building on the asset side of its balance sheet. but, at the same time, on the liability side, there is an equivalent amount representing the currency issue of the bank. governments impose inflation tax on the society by borrowing from central banks. when such borrowings are effected, the government would give the central bank a government security such as a treasury bill. the central bank, in return, permits the government to take away an equivalent amount of currency and spend it to make payments. so, on the asset side of the bank ’ s balance sheet, it has a treasury bill. on the liability side, this asset is matched by a new liability called currency issued by the bank. but, to acquire that asset, the central bank has to spend only a fraction of the face value of the asset enabling it to make a huge profit out of the transaction. central banks ’ lending to governments become highly inflationary on another count. that happens when the commercial banks make use of this currency issued by the central banks as seed money to produce more bank money in the form of deposits. when governments spend the currency borrowed from central banks, such currency finally gets back to commercial banks as deposits of the public. commercial banks, in turn, use such deposits to create more deposits and credit. they create deposits and credit in multiple terms restricted only by the public ’ s preference for currency as against deposits and banks ’ own need for keeping a safe cash reserve to meet public ’ s demand for cash. in sri lanka, commercial banks could create bank money five times higher than the initial amount of currency issued by the central bank. because of this ability to self - produce in multiple terms, ( in sri lanka, that multiplier