The Competitive Externalities and the Optimal Seignorage

The purpose of this study is to analyze the behavior of the inflation tax in an economy where, due to coordination failure, the inflation rate is not determined by a unique policy maker but by several competing decision makers. Each decision maker can effectively print more paper money via the central bank, which operates only as the printing agency of nominal balances. This market structure generates a competitive externality. A key result is that the optimal' inflation rate depends positively on the competitive externality. We provide two examples of scenarios where these externalities are relevant. First, the case in which the central bank is a powerless agent whose only responsibility is to print money upon demand by the ministers. The second example is a common currency area, where several countries operate in a monetary union. Alternatively, this may be the case of a country composed of several states or provinces, where the centralized government system is weak and local governments can use seigniorage to their advantage. The effect of competitive externalities is to increase the inflation rate, to an extent that puts the economy on the wrong side of the inflation tax Laffer curve.