How does Seigniorage impact central bank independence?

Seigniorage means the difference between the face value of the money and the cost of producing it. The central bank of any country plays a vulnerable role so it should be an independent organization.  But in some situations, the central bank is affected to accomplish political intentions. For example, some governments force the central bank to create unnecessary money.

What is the role of the central bank?

We know that in the present world majority of the counties have a central bank with the intention of achieving stability and growth in their financial systems. In any economy, the central bank plays a very important and unforgettable role.

Because central bank performs very crucial economic activities such as conduct the monetary policy, create money, controlling the interest rates, act as a creditor for the government, act as a final fund provider to the commercial banks, and so on. Since the central bank of any country plays such a vulnerable role, it should be an independent organization. In other words, the central bank should be given a sufficient level of freedom to implement the monetary policy. (Walsh, 2010).

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But in some situations, the central bank is affected to accomplish political intentions. For example, some governments force the central bank to create unnecessary money, decrease the interest rates, and so on. This case created a higher level of inflation, especially hyperinflation. Hyperinflation or extremely rapid inflation means an increase in the general price level of a country by more than 50 percent per month.

In this study, I’m going to discuss about this matter.

How a government can cover its expenses?

A government has a different kind of expenses. So, it needs money to cover its expenses. It needs money to pay salary to government employees, to bear military expenses, to provide social services, and so on.  So, the government should find different ways to finance its expenses.

• The first one is, the government can implement taxes on the people and collect revenue. As an example, in Malaysia, the majority of the government income comprises the tax revenue. But if people don’t have sufficient recourses to pay taxes, the government cannot implement taxes.
• The second option is, the government can sell natural resources and collect revenue. The best example is the Middle East counties. We know that they have a higher amount of fossil oil and the government can sell fossil oil and collect money. But for the countries that are less with natural resources cannot do this.
• The third one is, the government can take loans from the people. In other words, the government can sell government securities such as Treasury Bonds and Treasury Bills to the people and collect money. But when people do not believe in government, in countries such as Zimbabwe, the government cannot sell government securities to the people. Because people do not buy government securities. 

How a government finance its expenses, if a government cannot collect money from the above-mentioned ways?

So, if a government cannot collect money from the above-mentioned ways, that government has to print more money and spend them to finance its expenditures. But, since there is no increase in the real output of the nation and only an increase in the money supply, this will create a higher level of inflation, especially hyperinflation. We can identify this as follows.

When a central bank prints more money under the pressure of the government, that increases the inflation rate of the country. Because increasing the nominal money stock decreases the real value of the money. But it increases the revenue of the government. This is called “positive seigniorage”.

What is Seigniorage?

Seigniorage means the difference between the face value of the money and the cost of producing it.

If the face value of the money is higher than the cost of producing it, there is a positive seigniorage. This will make a profit to the government and increase government revenue.

At a certain point of the inflation rate, government revenue comes to the maximum point of it. This point is called the “maximum possible revenue inflation rate”. But the government does not know that and it further prints the money with the intention of increasing revenue. 

So, after that point, if the government print more money, although the inflation rate is increased, government revenue will be decreased. The reason for this situation is “negative Seigniorage“. If the face value of the money is lower than the cost of it, there is a negative seigniorage. This will make a loss to the government and decrease government revenue.

Also, after the point “maximum possible revenue inflation rate” hyperinflation will be occurred. The general price level of the country will be rapidly increased.  This important relationship is presented by following “Laffer curve”. It was introduced by Arthur Laffer in 1974. Laffer curve shows the relationship between seigniorage and inflation rate including hyperinflation.

Real world examples

After world war one in Weimar Germany, there was a hyperinflation situation because of the printing excess money by the government. (Boesler, 2013). The price of the goods increased from a very higher rate because there was a higher amount of nominal money stock. The real value of the money was decreased rapidly.

Also, in the current world, Zimbabwe and Venezuela suffer from hyperinflation. There was a 401.66 percent monthly inflation rate for the month of November, 2020 in Zimbabwe. (Zimbabwe Inflation Rate, 2020). There was an 1813.1 percent monthly inflation rate for the month of September, 2020 in Venezuela.

Conclusion

  So, we can conclude that the government of a country should not force the central bank to create money on the behalf of the government. In other words, the government should avoid the “monetizing” of government spending, debt, or deficit. If not, that will create not only hyperinflation situation to the country but also it will make a negative seigniorage that will decrease the government revenue. So, the central bank of a country should be an independent organization and the government should not influence it to fulfill its wishes.

References

Boesler, M. (2013, September 20). WEIMAR: The Truth About History’s Most Infamous Hyperinflation Horror Story. Business Insider. https://www.businessinsider.com/weimar-germany-hyperinflation-explained-2013-9

Hyperinflation – Definition, Causes and Effects, Example. (2019). Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/knowledge/economics/hyperinflation/

Walsh, C. E. (2010). Central Bank Independence. Monetary Economics, 21–26. https://doi.org/10.1057/9780230280854_3