Monetary policy and seigniorage in Brazil: Open access and the role of state banks

A political economy model of competition for seigniorage is developed in this thesis in order to provide a rationale for the inflationary regime that the Brazilian economy went through until the advent of the Real Plan in July 1994. If states in a federation can transfer their debts to the central government or monetize them through a war of attrition against the Central Bank, then they will choose to do so if the central government is politically weak and the Central Bank lacks independence. States fight a war of attrition against the Central Bank by spending resources--for example, reorganizing forces in the Congress and pressuring the central government--to make the Central Bank concede and bail them out. State banks are the primary vehicle through which state governments increase their debts. Inflationary pressure is higher when: (1) states' costs of a war of attrition against the Central Bank are lower, (2) the state governors are less conservative toward inflation, and (3) states have more political access to the Central Bank. The higher the inflation rate the more likely the economy is on the wrong side of the Laffer curve. It is shown that these factors were present and increasingly important during the period 1987-1994 when Brazilian inflation was increasing rapidly. An important implication of this thesis is that whenever states in a federation face soft budget constraints, political and economic decentralization leads to waste and dissipation of rents, instead of enhanced welfare.