Seigniorage In Economics Meaning Formula Inflation Tax

Seigniorage in Economics Meaning

The term is also applicable to situations where a central bank lends money and earns interest from the exchange. Seigniorage in economics can be both positive and negative, where a positive seigniorage means that the government earns a profit, and the negative denotes a monetary loss.

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Understanding Seigniorage in Economics

Seigniorage is derived from the old French term “seignorage,” which was used to describe a feudal lord (“seigneur”) who had the right to mint money and collect revenue Revenue Revenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read morefrom selling it.

Key Takeaways

Seigniorage in economics is a government or central bank’s revenue from issuing new money.It isn’t very costly to produce the new money compared to the worth of actual money. However, some bills or notes are worth higher amounts, such as $20, $50, or $100. The difference between the cost to produce the currency and the money’s actual value is called seigniorage.The relationship between seigniorage and inflation can be observed through the Laffer curve. There is a particular point in which seigniorage is most profitable.The term is derived from the French term ‘seigneur’ which was used to describe a lord who minted money and earned a profit from selling it.

Money production involves two methods –namely, minting and printing.

In the United States, the U.S Mint is in charge of “minting” or making the coins such as pennies, nickels, dimes, and quarters. The U.S Bureau of Engraving and Printing, on the other hand, handles the “printing” or creation of paper currency such as the dollar bill.

This process of minting coins and printing paper currency comes with a cost. According to information from the Federal Reserve’s website, here is the price of printing per each U.S paper currency bill:

As shown in the table, the cost to produce the paper currency is much lower than the bills’ face value. For example, the cost to create a single $1 bill is only 6.2 cents, resulting in a 93.8 cents seigniorage.

This is how a central bank can profit and earn revenue from increasing the money supply. When commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more need money, they will borrow from the central bank. The central bank will then loan out the currency to the banks and charge interest on the money lent.

When financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more purchase bills from a nation’s central bank, the central bank will use the profits to invest in financial instruments such as bonds or treasury billsBonds Or Treasury BillsTreasury bills are debt instruments that the Central Bank issues on behalf of the government with less than a year tenure, and these have negligible chances of default risk. In contrast, the bonds are issued for more than or equal to two years. These can either be default or risk-free, depending on their type.read more. The interest from these investments is also a type of seigniorage. The government uses this profit to fund its various programs and other expensesOther ExpensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities.read more.

Real-World Example

Let’s take the example of the Bank of Canada to see how a government can raise revenue and earn seigniorage from creating and lending banknotesBanknotesA banknote refers to a country’s currency in the form of paper.read more (bills.)

Canada’s central bank, The Bank of Canada, produces the banknotes (bills) for the country, such as the $5, $10, $20, $50, and $100 bills. Just as it is in the U.S, the Canadian bills do not cost nearly as much to produce as their value.

For example, the cost to produce a Canadian bill is around 20 cents per banknote. The interest on investmentsInterest On InvestmentsInterest in investments is the periodic receipt of inflows on financial instruments which may be in the nature of the bond, government securities, or bank account. It is income earned from the specified form of assets which may be liquid in nature. read more equals around 2% per year.

Additionally, the cost to produce the $20 Canadian banknote is around 20 cents per bill.

To find the seigniorage earned by the Bank of Canada and the Canadian government, we will use the following formula:

Seigniorage = interest earned – cost to produce

Step 1: Finding the interest earned.

The interest is 2% per year x $20 bill = .40 or 40 cents per year.

Step 2: Finding the cost to produce the bill.

The cost to produce is around 20 cents per bill, and the $20 bill has an average lifespan of about four years.

20 cents ÷ 4 years = 5 cents per year.

Step 3: Taking the interest earned and subtracting it from the cost of productionCost Of ProductionProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. read more

(40 – 5) cents = 35 cents per year.

This example shows that for every $20 bill the Bank of Canada produces and puts into circulation, the government can collect 35 cents per year in seigniorage.

Does Seigniorage Cause Inflation

Inflation Inflation The rise in prices of goods and services is referred to as inflation. One of the measures of inflation is the consumer price index (CPI). Rate of inflation = (CPIx+1–CPIx )/CPIx. Where CPIx is the consumer price index of the initial year, CPIx+1 is the consumer price index of the following year.read moreis a broad indicator that refers to an increase in buying goods and services. Many things can cause inflation in an economy, such as a spike in aggregate demand.

Many economists agree that the rapid production of currency is another significant contributor to inflation, leading to a considerable increase in the country’s money supply. When a country increases its money supply faster than the supply of goods and services, it can lead to inflation as consumers will be willing to pay more for the goods.

With that being said, to answer the question, many economists consider seigniorage as a form of the inflation tax. Here’s why:

An inflation tax isn’t necessarily a tax in the form that we are used to. Instead, as one holds onto paper currency, such as the dollar bill, when inflation is high, the value of that currency is decreased. So when you go to buy goods or services, the money will be worth less than when you first obtained it.

The relationship between seigniorage and inflation can be observed through the Laffer curveLaffer CurveLaffer Curve describes the relationship between tax rate and amount of tax revenue government collect and shows that increasing tax rates do increase revenues for the government but only to a certain extent, after a certain level the tax income starts to decline with an increased tax rate. This theory was proposed by an economist named Arthur Laffer.read more. It shows that at a specific inflation rateInflation RateThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100.read more, seigniorage revenue will peak.

However, suppose a government is careless with issuing new currency and printing new money. In that case, it can cause inflation as the money supply is increased at a rate that aggregate supplyAggregate SupplyAggregate Supply is the projected supply that a business calculates based on the existing market conditions. Various factors such as changing economic trend are considered before calculating the aggregate supply.read more cannot match. Depending on how much new money is issued and the changes in aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more, inflation will affect the price of goods or services.