Copyrighted Material seigniorage money system, seigniorage revenue is given by the product of the inflation rate and the inflation tax base. This inflation tax base reflects the purchasing power of the public’s money holdings and is the level of real money balances (nominal money holdings divided by the price level). Undertaking more rapid monetary expansion causes the inflation rate to rise, but the revenue effects are partially offset as indi- viduals attempt to quickly spend the extra money before it depreciates further. If people spend money faster thanitis beingprinted, therateof price increase comes to exceed the rate of money issuance. Hyperinflation Agovernmentthatisunableto fund its expenditures through conventional taxes or bond sales may become dependent on seigniorage revenues to maintain its existence. Attempts to raise seigniorage revenues are, however, not only infla- tionary but eventually self-defeating. Under cir- cumstances where the decline in real money balances seigniorage becomes proportionately larger than the rise in the Seigniorage is profit from money creation, a way for inflation rate, the inflationary policy actually back- governments to generate revenue without levying fires and lowers seigniorage revenue. The economist conventional taxes. In the days of commodity Phillip Cagan’s classic analysis of hyperinflations, money, seigniorage revenue was the difference be- with inflation rates exceeding 50 percent per month, tween the face value of the minted coins and the suggested instances where the process had, in fact, actual market value of the precious metal they con- been pushed beyond the revenue-maximizing point. tained. When this markup was insufficient for the It is possible that lags in the adjustment of inflation government’s revenue needs, the authorities might expectations may actually have allowed continued substitute less valuable base metal for some of the seigniorage gains, however, and subsequent analysis precious metal that was supposed to be in the coins. of the 1921–23 German hyperinflation points to Such a practice has a long history, dating back at least seigniorage levels rising year by year (see Cukierman to Roman times. Although this allowed the govern- 1988). ment to issue more coins without acquiring more Whatever success the German government may precious metal, the coins quickly depreciated as have attained in raising seigniorage revenues, such agents became aware of their less valuable content. surging, and highly volatile, inflation rates interfere The continued partial precious metal backing still with the price mechanism and cloud production and placed some limit on the possible issuance. employment decisions. Meanwhile attempts to With the demise of the gold standard in the early economize on money balances require devoting 1930s, almost all nations abandoned commodity- more and more time to simply turning over the backing for their currencies and adopted a fiat money currency. By the end of the German hyperinflation, standard under which the paper issued is backed by workers were being paid more than once a day be- nothing more than faith and confidence in the issuer. cause otherwise the value of the money would fall too Under this system, the cost of issuance declines close much between the beginning and end of the shift! to zero and there is no longer any limit on the Other innovations, such as the indexation of bank quantity of money that can be issued. Under a fiat deposits to inflation or establishing deposits de- 992 Copyrighted Material nominated in a stable-value currency, require even bank, is likely to be far less inflationary and has no seigniorage faster rates of note issue to maintain seigniorage direct effect on the money supply. revenues, given that part of the money supply is now Making the central bank independent of the fiscal insulated from the inflation tax. This factor was authority would seem to be a way of ending auto- particularly evident in the record-breaking post– matic government access to the printing press, and World War II Hungarian hyperinflation. Negative nations with independent central banks have his- effects on economic growth emerge well before such torically tended to have lower inflation rates. But extreme circumstances, however. Recent work sug- even in the United States, large deficits such as those gests that significant negative effects of inflation incurred under the Reagan administration put con- may emerge below the 10 percent level in both in- siderable pressure on the central bank to at least dustrial and developing economies (Burdekin et al. partially monetize them insofar as very large bond 2004). issues push down bond prices and put upward Certainly, even though conventionaltaxes impose pressure on interest rates. Moreover in a developing their own distortions on the economy, few would economy where the market for government bonds is argue that this justifies reliance on seigniorage as a much thinner, it is unrealistic to expect the central deliberate policy choice. Dependence on seigniorage bank, nominally independent or not, to resist mon- revenue seems, in practice, to be highly correlated etization pressures when no other financing options with the degree of political instability. Vulnerability exist. Instituting central bank independence is to this effect tends to be greatest in developing probably better thought of as a way of discouraging economies that are less democratic and/or more so- future fiscal profligacy rather than something that cially polarized (Aisen and Veiga 2005). High in- alone can end an ongoing reliance on deficit mon- debtedness is another common factor. In this respect, etization and seigniorage. even a government that is initially able to fund its Reducing Reliance on Seigniorage Revenue A deficit through selling bonds to the public may more drastic way of weaning a government away eventually resort to inflation finance as the amount of from reliance on seigniorage revenue is to dollarize debt approaches the saturation point. Thomas Sar- the economy, following the example of countries like gent and Neil Wallace argue that such ‘‘unpleasant Panama (since 1904) and Ecuador (since 2000), monetarist arithmetic’’ implies that, in the face of which abandoned domestic currency issuance and continued budget deficits, tighter monetary policy adopted the U.S. dollar as their monetary standard. today simply implies more inflationary policy to- Another option is to maintain the domestic currency morrow once the limit on bond issuance is reached but link it to the U.S. dollar or another currency via a (see Sargent 1993). Furthermore the greater the currency board arrangement, whereby the monetary outstanding stock of bonds, the greater the potential authority commits to exchange local currency for the governmental gains frominflating awaythe realvalue foreign currency on demand at a predetermined, of these obligations through inflation—which, in fixed rate of exchange. Such a strategy still allows for turn, likely limits the demand for such bonds unless some seigniorage revenue on interest-bearing dollar- inflation protection is built in. denominated assets held to back the local currency. The typical mechanism of inflation finance is for Although Hong Kong’s currency board arrangement the government to sell bonds to the central bank, with the U.S. dollar has been maintained since 1983, which then immediately ‘‘monetizes’’ the debt with Argentina’s link with the U.S. dollar collapsed in new money emissions. This is therefore properly 2001 in the midst of soaring unemployment and characterized as money finance rather than true bond political unrest. The Argentinean case not only finance and provides the government with new funds illustrates the potential dangers of tying the do- to spend only via excess money creation. Conversely mestic currency to the dollar but also serves as a re- selling bonds to the public, rather than the central minder that no such announced commitment is truly 993 Copyrighted Material irrevocable. Another alternative is to enter into a Cukierman, Alex. 1988. ‘‘Rapid Inflation—Deliberate currency union,such asthe eurozone, thateliminates Policy of Miscalculation?’’ Carnegie-Rochester Conference the scope for domestic inflation finance by dispens- Series on Public Policy 29, edited by K. Brunner and B. ing with the national currency entirely yet allows McCallum (autumn 1988), 11–84. Reprinted in P. participating nations to share in seigniorage revenue Siklos, ed. 1995. Great Inflations of the 20th Century. earned by the group as a whole. Aldershot, UK: Edward Elgar. Reexamines the sei- gniorage revenue raised during the post–World War I See also commodity-price pegging; common currency; German hyperinflation and suggests that the inflation currency board arrangement (CBA); currency crisis; cur- may have been more profitable to the government than rency substitution and dollarization; dollar standard; euro; the original Cagan analysis implied. European Central Bank; Federal Reserve Board; gold Gros, Daniel. 2004. ‘‘Profiting from the Euro? Seigniorage standard, international; money supply; multiple curren- Gains from Euro Area Accession.’’ Journal of Common cies; quantity theory of money Market Studies 42 (4): 795–813. Examines the distri- FURTHER READING bution of the European Central Bank’s seigniorage Aisen, Ari, and Francisco Jose´ Veiga. 2005. ‘‘The Political revenue and the prospective gains accruing to the new Economy of Seigniorage.’’ IMF Working Paper 05/175. member states from Central and Eastern Europe. Washington,