Dynamic Seigniorage Theory: an Exploration

59 Pages Posted: 20 Nov 2000 Last revised: 2 Aug 2008

See all articles by Maurice Obstfeld

Maurice Obstfeld

University of California, Berkeley; Peterson Institute for International Economics; National Bureau of Economic Research; Centre for Economic Policy Research

Date Written: February 1989

Abstract

This paper shows that the optimal extraction of seigniorage implies a strong tendency for inflation to fall over time toward its socially optimal level. The point is made using a multi-period model in which (i) the government can finance deficits through bond issue or money creation, (ii) private-sector expectations are rational, and (iii) the government sets the inflation rate each period in a discretionary manner. One way to view the model is as a synthesis of the "tax-smoothing" theory of government deficits, which predicts that the inflation tax follows approximately a martingale, and of models of discretionary policy making, which predict (absent reputation effects) that inflation is likely to exceed its socially optimal level. Both predictions are modified when the two approaches to explaining inflation are merged. Reputation effects play no role in the analysis.

Suggested Citation

Obstfeld, Maurice, Dynamic Seigniorage Theory: an Exploration (February 1989). NBER Working Paper No. w2869. Available at SSRN: https://ssrn.com/abstract=227234

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