The Political Economy of Monetary Financing without Inflation

Abstract

The operational framework of monetary policy can significantly alter macroeconomic outcomes and distributional dynamics. By managing the price and quantity of reserves, central banks can generate substantial seigniorage while maintaining price stability. I develop a leading-edlge modelling 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 redistributes bank profits, and the optimal reserve supply balances fiscal revenues versus 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 of 100%) or strongly negative reserve rates maximize welfare by nationalizing all returns to liquid wealth and reducing the effective interest rate on government debt to zero. The poorer majority would support such a framework.

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