Abstract

Contrary to most traditional studies which focus on the distributional effects of inflation, this paper theoretically examines how income distribution can be a determinant of inflation. Using an overlapping-generations model, this paper shows that inflation in the steady state under financial "undevelopment," defined as both the rich and the poor hold money, is higher than it is under financial "underdevelopment" where only the poor hold money Furthermore, inflation will be higher if the income of the poor when they are old is lower. Thus, more unequal income distribution can lead to higher steady-state inflation. This is because the government can extract more inflation taxes, which have a lower incidence on the rich people than a progressive income tax does. This may explain why higher inflation rather than tax reform is chosen in the political process, particularly among non-democratic countries. We apply both OLS and GIVE estimation techniques to cross-country data for 90 countries over the period 1950-92. Our hypothesis is supported by the results for a subsample of 56 non-democracies, which indicate that inflation is related positively to money supply growth and the Gini coefficient but negatively to the level of financial development. (JEL D30, E31, E58, H22)