Roberto Bonfatti, Adam Brzezinski, K. Kıvanç Karaman, Nuno Palma 27 September 2020

Even a cursory review of the evidence on the developing countries today and states in earlier historical periods hints at a close relationship between monetary and fiscal capacity. Breakdowns of monetary systems tend to bring about falling tax revenues and the collapse of government authority, while fiscally troubled states fail to issue and circulate their own currency. Beyond the anecdotal evidence, however, there is little effort to formally model the mechanisms through which monetary and fiscal capacity interact, to document this relationship over the long run, and to identify the causal effects.

Building on recent research (Bonfatti et al. 2020), in this column we address each of these three points in turn. First, we discuss the mechanisms through which monetary and fiscal capacity interact.  Second, we bring together money stock and tax revenue data for Europe from antiquity to the modern period, and evaluate the patterns. Finally, relying on the natural experiment associated with the massive inflow of silver and gold from America, we estimate the causal effect of monetisation on taxation for early modern England, France and Spain. The results indicate that money is not neutral in the long run, and the trajectories of economic and political development are interdependent.

Modelling the relationship between monetary and fiscal capacity

In broad terms, this column investigates the relationship between monetary and fiscal capacity. Monetary capacity refers to a state’s capacity to provision and circulate money that is accepted by the public, which in turn determines the monetisation level of the economy. This capacity depends on demand-side factors, such as the public’s willingness to accept state-issued money.1 It also depends on supply-side factors, which, in the commodity money era, included the availability of silver and gold. Fiscal capacity, on the other hand, refers to a state’s administrative and political capacity to raise taxes, and determines the level of taxation (Besley and Persson 2011). This capacity depends on the physical infrastructure, bureaucratic know-how and coercive capabilities of the state.

Long-run evidence offers two insights about monetary and fiscal capacity. The first insight is that the public demand for money decreases with the expected inflation rate. The second is that a higher monetisation level eases the collection and administration of taxes (Tilly 1993). It eases the collection, because it expands the role of markets, and markets are easier to monitor and tax than non-market activities. Monetisation also eases the administration of taxes, because once collected, money taxes can be conveniently transported and governed in a centralized way, whereas taxes in kind cannot. 

We use a two-period model to establish that these insights together imply a dynamically reinforcing relationship between monetary and fiscal capacity. On the one hand, greater fiscal capacity induces the public to hold more money, because expected inflation is lower. On the other, greater monetary capacity induces a government to invest in building fiscal capacity, because it is easier to tax a monetised economy. In the long run, monetary and fiscal capacity support each other. Furthermore, any exogenous increase or disruption in monetary capacity spills over to fiscal capacity, and vice versa.

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Long-run patterns

We also bring together the long-run evidence for Europe, providing empirical support for the interdependence of monetary and fiscal capacity. The evidence indicates that, from antiquity to the Middle Ages, money stocks and tax revenues moved together through several cycles of ups and downs. The discovery of vast amounts of silver in the New World put an end to these cycles, and led to a permanent increase in both money stocks and tax revenues in Western Europe. This New World silver shock also serves as a natural experiment and allows us to estimate the causal impact of monetary capacity on fiscal capacity. 

From antiquity to the Middle Ages, the available evidence identifies three peaks in money stocks and tax revenues, and throughs in between. The first peak was at the 5th century BC Athens, with per capita money stocks reaching a level of around 200 grammes of silver, and per capita tax revenues reaching 10-15 grammes. The second was Pax Romana, with money stocks of 50-100 grammes and taxes of 10-15 grammes of silver per capita.  For the Middle Ages, the quantitative evidence is scanter, but indicates a peak in the early 14th century. Each of these peaks were associated with surges in silver production, respectively at Laurion, Iberian and central European mines.

The discovery of silver in the New World ended these cycles of monetization and demonetization and had a transformative impact. Figure 1 puts this impact in perspective, by presenting the available per capita money stock estimates. Around 1500, per capita monetary stocks of Western European states were around 50-100 grammes of silver. By 1800, they had increased to 300-1000 grammes. The Figure also indicates a much more muted impact on Eastern Europe. The silver diffused to the East only in limited amounts, and per capita money stock levels remained stagnant.

Figure 1 Money stock per capita, 1150-1800

When the evidence on tax revenues is added to the picture, it corroborates the close relationship between monetary and fiscal capacity. Moreover, this close relationship remains robust after accounting for the changes in price and income levels. Figure 2 summarises the evidence. The top panel plots the relationship between money stock per capita and tax revenue per capita, in grammes of silver, for eight states over three centuries. The middle panel plots the same two variables, after dividing them both by the cost of a standard consumption basket, to account for the changes in price levels. Finally, the bottom panel plots the two variables after dividing them by nominal wages, to account for changes in incomes. In all three panels, there is a strong positive correlation between monetary and fiscal capacity both across countries and over time.

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Figure 2 Per capita money stocks and tax revenues, 1500-1800

Empirical analysis

The discovery of the New World also offers a unique natural experiment to go beyond correlations and estimate the causal effect of monetary capacity on fiscal capacity. The fluctuations in the production of precious metals in the New World, it has been shown, were exogenous to European conditions (Palma 2019). Using a local projection–instrumental variable (LP–IV) approach (as adopted by Jorda et al. 2020), we instrument European money stocks by the American precious metal production, and estimate their impact on tax revenues across different time horizons. The sample period is between 1550, when American silver began to arrive in large quantities, and 1790, when paper monies increasingly replaced commodity money and weakened the link between precious metals and money stocks. The sample countries are England, France and Spain, as these countries were heavily impacted by the New World shock and also have detailed historical data for both monetisation and taxation levels.

The results, summarised in Figure 3, identify a significant and substantial causal impact of monetary capacity on fiscal capacity. In the first stage, we find that an increase in the production of precious metals in the Americas resulted in higher monetary capacity (as proxied by the per capita real money stock).The second-stage results suggest that a 1% increase in monetary capacity raised fiscal capacity by 0.5%- 1% within a decade. This positive effect does not diminish over the course of subsequent decades. Hence, the impact of monetisation on taxes was permanent. 

Figure 3 Causal effect of a 1% increase of monetary capacity on fiscal capacity


In this column we argue that monetary and fiscal capacity, and in more general terms, markets and states are interdependent. Markets and states are often conceptualised as alternative methods of allocating resources and governing social interactions. This characterisation is incomplete, however, as they also depend on each other to function. Markets, and by extension, a monetized and commercialized economy facilitates state building, while a strong state fosters monetisation. For empirical evidence, we rely on the premodern period, as it allows a long-run perspective, and provides a natural experiment for identifying causal effects. The argument, however, is more general, and relevant for under-monetised economies both historical and modern.

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The co-evolution of monetary and fiscal capacity matters because they shape economic performance. Fiscal capacity allows states to integrate domestic markets, provide public goods, and solve externality problems. It also promotes growth by financing legal capacity and the protection of property rights (Brewer 1988, O’Brien 2011, Rosenthal 1990). Monetary capacity, on the other hand, is itself a public good that pervades all sectors of the economy. It lowers transaction costs and facilitates trade and investment. Hence, understanding the evolution of monetary and fiscal capacity helps understand the patterns of long-run economic growth.

Our findings also offer new insights on one of the central ideas in macroeconomics, the long-run neutrality of money. The common wisdom in the literature is that money is neutral in the long run: an increase in money supply has no real effects, and only leads to a proportional increase in the price level. In contrast, we find that it did have a real long-run effect, in the form of an increase in fiscal capacity. The reason for this positive effect is that historically large segments of economies were not sufficiently monetised. Following a positive monetary shock, money penetrated into these under-monetized segments. Prices increased, but less than proportionally, because now a greater share of the economic activity relied on money. The growing monetisation in turn facilitated market transactions and increased tax revenues. Hence, the effects of the increase in money supply were real, and had economic as well as political implications.


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Bonfatti, R, A Brzezinski, K K Karaman and N Palma (2020), “Monetary Capacity”, CEPR Discussion Paper 15299.

Brewer, J. (1988), The Sinews of Power: War, Money, and the English State, 1688-1783. Routledge.

Jordà, O, S R Singh and A M Taylor (2020), The Long-run Effects of Monetary Policy. NBER Technical Report.

O’Brien, P K (2011), “The History, Nature and Significance of an Exceptional Fiscal State for the Growth of the British Economy”, Economic History Review 64(2): 408-446.

Rosenthal, J L (1990), “The Development of Irrigation in Provence, 1700-1860: The French Revolution and Economic Growth”, The Journal of Economic History 50(3): 615-638.

Tilly, C (1993), Coercion, Capital, and European States, AD 990-1992.


1 We focus on state-issued money, because historically, private monies rarely circulated at the national level, did not survive long without some form of government backing, and complemented state-issued money rather than displacing it.