Seigniorage, the welfare cost of inflation, and implications for monetary policy

This dissertation analyses the relationship between inflation and seigniorage revenue. A model is developed and applied to the economy of Sri Lanka. A finding is that in Sri Lanka, seigniorage increases with inflation up to a maximum revenue of 1.35 percent of GNP. The simulated relation between seigniorage and the rate of inflation with Cobb-Douglas utility appears to conform more closely with actual seigniorage data for Sri Lanka than the Laffer curve relation for seigniorage that arises from a model based on a Cagan money demand function. Parameter estimates for Sri Lanka suggest a higher welfare cost of moderate inflation than in other countries that have been studied. For example, the welfare cost for Sri Lanka, estimated at 1.88 percent of GNP, is well above the existing estimates of 1.44 percent for Israel and 0.3 percent for the United States.;The presence of financial intermediation increases the government's ability to extract revenue from seigniorage. For Sri Lanka, the maximum revenue from seigniorage increases from 1.35 percent of GNP to 4.7 percent with the introduction of financial intermediation. Of the two policy instruments considered, the rate of nominal money growth appears to have a stronger effect on seigniorage in comparison with the required reserve ratio. For example, the maximum seigniorage with a 100 percent reserve ratio and a fixed nominal money growth of 17.5 percent is only 1.6 percent of GNP against a maximum revenue of 4.7 percent when the reserve ratio and the real money growth are fixed at sample means. The trade-off between seigniorage and the welfare cost of inflation suggests that seigniorage can be increased by raising the reserve ratio and lowering money growth without any impact on the welfare cost of inflation. For example, for a given welfare cost of inflation of 4.5 percent of GNP, seigniorage can be raised from 2.3 percent of GNP to 3.6 percent by increasing the reserve ratio from 10 percent to 20 percent.