Seigniorage, Banking and Welfare Cost of Inflationary Finance

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Title: Seigniorage, Banking and Welfare Cost of Inflationary Finance
Author: Boateng, Kwaku
Contributor: University of Helsinki, Faculty of Social Sciences, Department of Political Science
Date: 2002-12-01
Language: en
Thesis level: master's thesis
Abstract: This paper analyses seigniorage in a deregulated economy of currency and deposits, where competition in the banking sector is imperfect. Much of the literature on seigniorage analysis central bank revenue due to its power to create money, thus neglecting the existence of a banking sector. These studies consider only the inflation tax on currency (fiat or base money), ignoring demand for deposits. However in a world with a banking system, a substantial part of money balances takes the form of deposits held at commercial banks. The presence of a banking industry thus potentially changes the government revenues due to the desire of the private sector to hold real balances. This realization is the main topic of this paper. One key element that many studies on the macroeconomic foundations of bank behaviour and money supply process share in common is the assumption that the extent of rivalry in banking markets is a fixed parameter; i.e. the number and relative size of bank rivals in relevant asset markets has been taken exogenously determined. This assumption of a fixed level of market rivalry has been a reasonable one to make on empirical grounds. However, the recent trends toward deregulation of the banking industry are producing an environment in which the extent of rivalry among banks is likely to adjust freely to prevailing market conditions. Hence there is a need to rethink the behaviour of banks. This paper recognized this by assuming an imperfect competition in the banking sector and used model patterned closely upon the work of Vanhoose (1988), Barltensperger and Jordan (1997), Dasupta and Stiglitz (1981), and Saving (1977, 1979) to anlalyze the division of seigniorage between the central bank and the banking industry. In such deregulated market, banks behave oilgopolistically in an environment, where entry and exit are freely permitted. The fundamental proposition of our model is that with competition being imperfect, banks are able to set interest rates on deposits below their zero profit competitive levels. The central bank then has to share seigniorage, at least to some extent, with the issuers of deposits. The model is also used to analyze the comparative static effects of changes in inflation (interest) rate, reserve requirements, competition and technology on the division of seigniorage and some other qualitative issues raised by the presence of banking sector. Seigniorage also induces welfare loss, so the paper also looks at the possibility for the central bank to increase its revenues without increasing the existing welfare loss. The main conclusions of the study are that total seigniorage decreases with the degree of competition in the banking industry and financial innovation and increases with the interest rate and reserve ratio. The lower the level of competition and reserve ratio and the more advanced the payment transaction technology, the greater the share of seigniorage going to the banking sector. In addition, from the public finance point of view, it is optimal for the central bank to reduce bank seigniorage as far as possible, because bank seigniorage has no direct utility for the public. Therefore to enhance welfare, bank seigniorage should be eliminated completely Finally, a given amount of seigniorage revenue can be collected at either a high or a low rate of inflation. Therefore as a background to the main subject of the paper, we first demonstrate the existence of the double equilibria in a simple model in which money is the only source of deficit financing. We show that under rational expectations the high inflation equilibrium is stable and low inflation equilibrium unstable; under adaptive expectations it may be the low inflation equilibrium that is stable.
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Subject: seigniorage
adaptive Expectation
rational Expectation
inflationary Finance

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