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“A monetary system is like some internal organ; it should not be allowed to take up very much of one’s thought when it goes right, but it needs a great deal of attention when it goes wrong”. [ D. H. Robertson]
Since the beginning of 1990s many developing countries had experienced extreme instability in the exchange rate of their domestic currency. Though some could have come out with stability of their currency regime, many suffered for a long time. This instability in the financial sector has a profound effect on the growth and stability of the real sector of the economy. This chapter will explore all these aspects in greater detail. Money in the modern world is a fiat paper currency as its intrinsic value depends on the legal guarantee of the sovereign government. By issuing paper currency the government earns income that is known as seignorage in the monetary theory. Seignorage ( SNG) is defined in the literature as:
…. a duty levied on the coinage of money for the purpose of covering the expenses of minting , and as a source of revenue to the crown, claimed by the sovereign by virtue of his prerogative.
[ McKinnon, 1979: p. 283] According to Professor S. Black (1998), seignorage is the excess of the face value over the cost of production of the fiat money. The rationale why the issuer should get the seigorage is that the minting of money makes its supply limited and for the resulting limited supply money yields a rent that should go to seigneur. One interesting aspect of SNG is that it remained more or less absent during the era when money meant metallic coins, either silver or gold. The reason was obvious as the difference between the face value of the coin and the cost of production including the cost of the metal was not significant. This prevented the rulers to issue reserve money for the sake of reaping the SNG. The invention of paper money facilitated the process as such type of money could be released in the economy with a minimum cost. During the period of metallic currency, principal gain from SNG was the premium or the commission charged when the coins were first released to the economy. Once the money was released, coins were to be maintained at a cost for its storage and transport. Even coins used to lose its weight through wear and tear leading to the situation that face value of the coin became less than the metal value.
During the regime of metallic coin, excess supply of money leading to inflation should be a rare phenomenon as that would necessitate a large supply of the metal at a relatively less cost. Inflation in a commodity money situation may happen only when the commodity used in the minting of coins becomes excess in supply and also cost of minting of coins becomes less. Both are unlikely events and so we see a long period of price stability during this phase of history. But once paper money came into circulation, these commodities, like gold and silver, were released for other social use. In a sense the introduction of paper money brought huge amount of social savings in the society. But the introduction of paper brought huge advantage to the governments as they found in it larger scope of marshalling resources from the economy by giving paper money, which is very cheap to produce. This is the disadvantage of fiat money as a system. The intrinsic value of paper money depends on strict control on its supply and the legal backing of the government. But its cheapness leads to its abuse by the issuer and then it loses its credibility. In this perspective J.M. Keynes observed:
There is no subtler, no surer means of overturning the existing basis of Society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction…..
[ Keynes, 1923; p. 80 ] We have observed that paper money, also called fiat money, has no intrinsic value. Fiat money can retain its market perceived value if asset- holders remain confident that its rate of supply to the economy will remain strictly controlled. This remains true because the demand for paper money is derived from how readily it is accepted rather than how fully it is backed. This has been proved many a time through historical events and more recently it is revealed in the events of Thailand, Indonesia, South Korea, Russia, Brazil and Argentina. The governments of these countries fully backed their currencies. In spite of that the individuals and institutions that were holding monetary instruments denominated in these currencies lost confidence in the credibility of the governments and substituted away from these financial instruments. The public perception was found true when it was revealed that the central banks of these countries were unable to purchase the domestic currencies at prices fixed by them. That led to large scale devaluation of these currencies as were seen in cases of Thai baht, Indonesian rupiah, Russian rouble, and Brazilian real etc. One important element common in all the cases as stated above is that the governments of these countries tried to finance their budget deficits by the seignorage reaped through the increase in the supply of money. This makes SNG inter-related to budget deficit and inflation. We are to discuss this aspect. 8.1. Measurement of Seignorage The common measure of SNG is the real rent from issuing reserve money, and it is defined as currency in circulation plus reserve of the bank held by the central bank. The real rent is computed as the change in the reserve money divided by the price level. This we can write: 124
SNG = d M / P
Here d denotes change in the sense of differential calculus, M the reserve money as defined and P the price level. Since the differential d (M/P) can be expanded as; d( M/ P ) = [ P . dM − M . dP ] / P2 = d M / P − ( M /P ) . d P / P, therefore, dM /P = d ( M/P) + ( M / P ) . П where П = dP / P i.e., rate of inflation. Combining Equations (8. 1) and ( 8. 2) , we can write, SNG = d ( M / P ) + П . ( M / P ) … Equation 8. 3 …. Equation 8.2
The SNG has two components. The first term on the right is the change in the real reserve money. It measures the increasing command over the commodities available to the government through ts release of additional reserve money. The second term is the inflation tax that the authority collects from the holders of fiat money as the extent to which inflation erodes the intrinsic value (purchasing power) of the fiat money held by the public. It measures the capital loss suffered by the holders of paper money as price level changes. One interesting aspect of fiat money is that once the asset holders start thinking that the supply of fiat money is far in excess than what is warranted, the newly issued money debases the existing money in circulation. This is equivalent to the capital loss of the holders of the fiat money, and the first term is a measure of that as it indicates the change in the real reserve money. 8.2. Broader Measure of Seignorage A rapid expansion of reserve money and hence money supply can lead to a gain to the government in the form of inflation tax and seignorage, and it may lead to a cost as the holders of existing money stock think it as a form of capital loss. This capital gains or losses induced by a rapid expansion of money supply can be measured by making the concept of seignorage a bit broader. This can be pursued by using the stylized set of accounts for the monetary authority that McKinnon used. According to McKinnon (1979), total assets consists of money reserves and investment denoted by I and total liabilities consists of deposits, say D. From this SNG is computed as SNG = r. I − r* D − C Where, r = open market rate of interest on investment Equation 8. 4
r* = deposit rate of interest on holding of international currency C = cost of servicing the existing stock of money One implication of this McKinnon identity is that if the government has large external liability ( that makes a negative I, or I < 0 ), it will lose seignorage. This is an interesting result as extended money creation by the government leads to loss of revenue on account of SNG. We will see later more on this. Professor M.J.M. Neumann (1992) has deduced a formula of “extended seignorage” (ESN) by using a similar format. His identity is: ESN = SNG + ( i D + i* F + GR )/ P Where, ESN = extended seignorage SNG = seignorage as defined above i = interest rate on the stock of private debt ( D ) held by the monetary authority i* = interest rate on official foreign loan made by the monetary authority F = amount of foreign loan of the authority P = consumer price level GR = unrealized capital gains on assets These equations put together a system that links inflation, seignorage, exchange rate movements, interest rate, fiscal deficit and some other macro variables. We can show the link between seignorage and exchange rate movements through a simplified version of monetary authority’s accounts. Whenever there is changes in the balance sheet of the monetary authority, reserve money changes. Put in symbols, change in the reserve money (d M) is the sum of the changes in the net foreign assets ( d F), changes in the net domestic credit ( d D) and change in other items ( dZ). We can write, dM =d F + d D + dZ Equation 8. 6 Equation ( 8.5)
where Z = proxy for other items, or parameters that influence macro variables in the economy. Dividing through by the price level P, we write dM / P = dF / P + d D / P + dZ / P Similar to Equation ( 8.2), we can manipulate Equation 8.7
d( F/P) = dF /P – (F/ P ). dP /P, or, dF/ P = d( F/P ) + П . ( F/ P) Similarly, dD / P = d( D / P) + П .( D /P) and, dZ /P = d( Z /P) + П .( Z /P) Equation (8.8) Equation (8.9) Equation (8. 10)
Combining Equation (8.7) to ( 8.10) we can write, dM /P = d( F /P) + П . (F /P) + d( D /P) + П . (D /P) + d( Z/P )+ П.( Z /P) Equation (8.11)
We can now interpret equation (8.11). We see that the generation of SNG depends on factors that change net foreign assets, net domestic assets and net change of other items (Z) being a proxy of some macro variables, along with rate of inflation and the extent the latter affects the parameters as mentioned. 8.3. Seignorage and Exchange Rate Net foreign asset F can be written as F = e . F* , When, F* = dollar value of foreign assets, and e = exchange rate of domestic currency. Expanding the expression we can write, dF = de. F* + e. dF* , or after a little manipulation , we get dF / P = [ de /e + dF* /F* ]. F /P Equation (8. 13) When money supply is increasing rapidly, both the exchange rate ( e) and the dollar value of foreign liabilities will increase. This means both de and dF* will be positive. For a highly indebted country, net foreign asset ( F /P) will be negative and that makes the value of the right hand side of [ 8.13] negative. When net foreign assets of the monetary authority are large and negative, the effects of exchange rate changes [ as measured by dF/ P in equation 8.13 ] subtract in a major way from the generation of SNG as in Equation 8.11. So a country with huge foreign Equation 8.12
liability and high inflation is caught in a bind as further money creation leads to a negative seignorage and more money creation is needed to compensate the latter. This aspect will be clear if we analyze the cases of two highly indebted countries, Russia and Zambia: Table: Seignorage and its Components: year 1997 Country dM /P dF/P dD /P F* a**b** 1 2 3 4 5 6 Russia 1.76 0.49 1.27 1.85 0.10 Zambia 1.22 -- 0.15 1.36 - 28.6 - 2.27 Note: a** = (de /e). F /P, b** = (df /f ). F /P Source: International Financial Statistics, IMF, March, 1999. 7 0.36 1.92
Column 4 shows direct gains from seignorage to GDP. Its value becomes low when the growth of reserve money becomes fast. In case of Zambia, growth of money supply became very high, that reduces the value of the gains from seignorage to GDP. In column 3, the value shows the effects of exchange rate changes. When net foreign assets of monetary authority are large and negative( liability ), the effects of exchange rate changes subtract in a major way from the generation of seignorage. Here the data of Zambia are striking as the figure is negative. 8.4. Dynamic Effects Some economists prefer the study of the dynamic effects of reserve money changes. In the developed countries the growth of reserve money is stable and budget deficit does not lead to money creation. That leads to the discussion of seignorage in terms of a “steady state” equilibrium. But critics point out that in the developing countries the growth of the reserve money is volatile and rapid. Even the economists have emphasized the existence of a Laffer Curve [named after Professor Laffer showing retrograde relation between rate of tax and tax revenue ] relating seignorage to rate of inflation and growth of reserve money in the perspective of hyper-inflation. The idea boils down to the existence of an optimum seignorage point and whether a country makes a transition back to optimum point once it crosses the limit. Economists argue that this transition is very important for the highly indebted countries that have moved beyond their optimum international credit limits. They find themselves in a dilemma ---they are caught in a spiral of accelerating inflation as they try to gain access to the increasing amount of foreign exchange needed to meet the debt service obligations. As the rate of reserve money creation increases, the task of meeting foreign obligations becomes increasingly difficult.
From the theoretical exercise above we can write briefly the policy implications faced by the highly indebted countries today. The countries that face twin problems of a large amount of foreign debt and its servicing obligations and a potential high inflation may have the temptation of servicing the foreign debt obligation by the creation of reserve money and appropriating the seignorage. But this boils down to the large scale debasement of the domestic currency and hyper inflation. In such a situation the country can better seek a rescheduling of debt obligation even if that means a default and adverse international repercussions. 8.5. Cost of Seignorage Some developing countries are prone to maximize revenue from seignorage, and in the process these countries face trouble in unstable currency. There is also a cost of seignorage and that can be placed as follows. The important cost of SNG is the resource cost of printing, issuing, storing and maintaining the stock of fiat money. Sometimes countries facing very high inflation are to import large stock of printed currency at a substantial cost. Another cost of SNG is the ‘inflation tax’ imposed on the economy as hyperinflation sets in. The authority may collect resources through inflation tax, may even facilitate a desirable redistribution of income, but this also leads to currency substitution and a capital loss on fixed- income liabilities. The literature has noted that through currency substitution and asset substitution the public can reduce their holdings of financial instruments denominated in domestic currency. The asset holders in unstable economies having track record of high inflation have become efficient in using this method and this way they insulate their assets from the negative effects of monetary disruptions. This situation is common in countries like Russia, Argentina, Peru , Bolivia, Serbia and some others. A country with a large external debt faces capital loss when hyperinflation becomes chronic. A commitment to repay foreign liability is associated with several risks. International interest rates may increase, and that will increase the cost of debt. The country faces same effects when the domestic currency depreciates. While the first increases the cost in foreign exchange, the second increases the cost in domestic currency. 8.6. Conclusion The monetary authority enjoys seignorage and inflation tax through the release of reserve money. So long the latter maintains an equilibrium relation with the country’s GDP and other macro parameters, the economy faces no problem. Instead the society as a whole is benefited by the positive externality of the existence of money as an institution. Apart from that the control of reserve money gives several benefits to the authority and these are: (i) accrual of monopoly rents due to the difference of yields on official liabilities, and (ii), real gains to the issuers of financial instruments.
The authority gets the monopoly rents as the official financial instruments held by the private sector at rates below the market rates. One example is the reserve requirements of banks. The authority issues fixed coupon bonds and when inflation continues due to rapid increase of reserve money, the real value of these bonds are deflated. The difference between the face value of the bond and the real value is the gain to the issuer. Does sovereign money matter? Or, is it a desirable thing in the global scene that some 190 plus independent nations should have their own sovereign currencies? These are a bit complex questions. In the above we get the theoretical backdrop about the cost and benefit of the issuance of reserve money, and now we are in a position to pursue this issue in the next chapter.
Web Sources:: www.standardandpoors.com This is the web site of Standard and Poors. It provides data on macro parameters of many countries. www.rbi.org.com This web site is of Reserve Bank of India. It provides wide range of information about the economy of India.