Seigniorage and the relationship between monetary and

Transcript Seigniorage and the relationship between monetary and

JEM027 Monetary Economics Seigniorage and the fiscal dominance problem

November 10, 2014 Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague

Motivation (1/2)

▪ The need of monetary policy to generate seigniorage in order to cover fiscal costs may in extreme (but historically quite common) cases generate hyperinflation: Cagan (1956) JEM027 – Monetary Economics 1

Motivation (2/2)

▪ In less extreme – but still quite unpleasant – situations, the “

fiscal dominance

” problem may emerge -----------------------------------------------

Seminar topic:

▪ But central banks are not always “money-making machines” – there are even loss-making central banks (including the CNB in the past) ▪ Does financial weakness force a CB to resort to higher inflation? JEM027 – Monetary Economics 2

What is seigniorage?

Monetary seigniorage Monetary income

(opportunity cost seigniorage) ▪ ▪ ▪ ▪ … where

is monetary base

CU RE

is currency is bank reserves

is price level ▪ ▪ ▪

is real GDP

is nominal interest rate

I r

is interest rate on bank reserves Note: There are other definitions of seigniorage (fiscal seigniorage, total seigniorage etc.), but I do not find them very useful. Let us stick to the traditional ones JEM027 – Monetary Economics 3

Monetary seigniorage and income

▪ Monetary income is not equal to monetary seigniorage; they are equal only in special cases ▪ If the real IR = 0, then monetary income = “

inflation tax

” (Friedman, 1971) Inflation tax … where

is rate of inflation ▪ Economic relationship between monetary seigniorage and monetary income:

analogy with cows and milk

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Stylized balance sheet of a central bank

Assets

Net foreign assets (FA CB ) Net claims on gov’t (GD CB ) Net other assets (OA CB )

Liabilities

Monetary base (MB) = currency (CU) + reserves (RE) Net equity (E CB )

Example

: effect of permanent increase in

on CB‘s profits JEM027 – Monetary Economics 5

Cagan model

S ▪ “

Laffer curve

”

μ*

Inflation JEM027 – Monetary Economics 6

Optimal rate of inflation

μ*

Inflation ▪ Trade-off between distortionary taxation and distortions due ▪ to inflation Optimal inflation is generally positive JEM027 – Monetary Economics 7

Sargent and Wallace (1981) (1/4)

▪ ”Some Unpleasant Monetarist Arithmetic“ ▪ Assume an economy in which the quantity theory of money holds perfectly ▪ Monetary policy dominated by fiscal needs, must monetize budget deficits ▪ Economy grows at an exogenous rate (g) ▪ Real interest rate on government bonds assumed to exceeds economic growth

(r>g)

▪

Result

: lower money supply growth and inflation at present means higher inflation in the future ▪ If money demand depends on expected inflation: lower money supply growth may even lead to higher inflation now JEM027 – Monetary Economics 8

Sargent and Wallace (1981) (2/4)

A spectacular example of the potential effects of tight and loose monetary policy

For more detail see: http://www.minneapolisfed.org/research/QR/QR531.pdf

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Sargent and Wallace (1981) (3/4)

Primary deficit Seigniorage “Snowball effect” JEM027 – Monetary Economics 10

Sargent and Wallace (1981) (4/4)

b t+1 r>g d t μ t h t rg, primary deficits must be covered by seigniorage to make the budgets sustainable b t JEM027 – Monetary Economics 11

Darby (1983)

▪ ▪ ▪ ▪

”Some Pleasant Monetarist Arithmetic“

In reality

, i.e. the key assumption of the paper does not hold empirically In defence of Sargent and Wallace – if government debt exceeds some threshold, risk premium may increase, causing r>g (see the EA sovereign debt crisis) Note: this might lead to some self-fulfilling prophecies

10Y government bond yields (Maastrichat criterion)

Percent p.a.

10Y gov't bond yileds (Maastricht criterion)

30 25 20 15 10 5 0 Euro area Belgium Germany Ireland Greece Spain France Italy Portugal JEM027 – Monetary Economics 12

“Fiscal dominance” literature

Monetary policy Active Pasive Textbook good case Active Pasive P-level indetermin.

Fiscal dominance ▪ Note: inflationary surprises not only lead to higher seigniorage, but also erode nominal government debt ▪ ▪ ▪ Eric Leeper, 1991 (and others, e.g. Sims)

Textbook case

: MP is unconstrained and can actively pursue price stability by reacting sufficiently strongly to inflation; FP passively adjusts direct taxes to balance the budget

Fiscal dominance

: FP refuses to adjust taxes strongly, deficits are not financed entirely with future taxes; MP allows the money stock to respond to shocks to fiscal deficit JEM027 – Monetary Economics 13

Modern practice (1/2)

▪ ▪ ▪ CBs focus on price stability as their main goal Independent from government Prohibition of monetary financing ▪ “

Article 123 (ex Article 101 TEC)

Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

Seigniorage taken as a welcome by product helping to keep the central bank financially independent from the government, but generally low (less than 0.5 % of ” GDP, but typically even lower) in a low-inflation environment JEM027 – Monetary Economics 14

Modern practice (2/2)

▪ Crisis has changes the things a lot, stretching the mandates (and reviving interest in the fiscal dominance literature)

Overview of selected central banks primarily influencing long-term interest rates and the exchange rate Bank Outright purchases of financial assets Government bonds Covered bonds Other private assets Foreign currency Fed BoE ECB SNB

Enforced in 2010 by the Greek crisis (SMP: EUR ≈220 bn.; OMT not activated) JEM027 – Monetary Economics 15

Conclusions

1 2 3 4 5 6

Seigniorage often misused in the past as a source of government financing Potentially disastrous consequences (hyperinflations, or at least fiscal dominance) Financial independence of CB and strong prohibition of monetary financing an important element of modern institutional set-up Seigniorage typically well below 0.5% of GDP if inflation is low (a welcome by product of monetary policy, but nothing more…) During the crisis : quantitative easing/SMP  the modern set-up stretched to the extreme Some central banks (e.g. CNB) making losses (sterilisation costs/revaluation of FX reserves), others could follow soon; but this is unlikely to imply a threat of high inflation in countries with strong institutional background JEM027 – Monetary Economics 16