The Political Economy of Monetary Financing without Inflation

Abstract

By managing the price and quantity of reserves, central banks can generate substantial seigniorage while maintaining price stability. I develop a framework integrating heterogeneous households, incomplete markets, and an IO banking sector where banks hold reserves to hedge liquidity risk. Central banks control market rates by managing banks' liquidity demand. When the minimum reserve requirement (MRR) is non-binding, seigniorage acts as a tax on bank profits, and the optimal reserve supply compromises between fiscal revenues and elevated liquidity premia. All but the very poor would prefer this optimum over the current system. When the MRR binds, seigniorage becomes a tax on liquid wealth. Full-reserve banking (MRR = 100%) or significantly negative reserve rates maximize welfare by nationalizing all returns to liquid wealth and reducing the effective interest rate on government debt to zero. The less wealthy two-thirds of the population would favor such system with full reserves or negative reserve rates.

Keywords: Reserve Banking, Seigniorage, Inequality, Monetary Theory JEL: E42, E51, E58, E63