The tax-foundation theory of fiat money

Throughout modern history governments have tried to promote the general acceptance of their unbacked paper currencies. One of the most common devices has been legal tender laws that have assured the acceptance of these currencies as tax payments. Economic theory has largely ignored this mechanism, except for the static models of Starr (Econometrica 42:45-54, 1974; Econ Theory 21:455-474, 2003). I provide the first dynamic model of this mechanism, thus showing explicitly the medium of exchange role of money, accounting for expectations about the government's survival, and enabling more realistic taxation systems. I show that a stable government can promote its currency by refusing to accept other objects in tax payments. While this mechanism has similarities to convertibility, it differs from it on a critical aspect: with this mechanism the government can often keep its favorite money in circulation even while increasing its quantity and thus causing it to decrease in value. This opens the door for a successful inflationary policy.