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Money demand and seignorage - maximizing inflation

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  • Easterly, William
  • Mauro, Paolo
  • Schmidt-Hebbel, Klaus

Abstract

There is widespread consensus among economists that high inflation is often caused by the government's need to raise seignorage to finance high budget deficits. Depending on the shape of the money demand function, steady-state seignorage may follow a Laffer curve, where seignorage first rises and them falls with higher inflation. If so, a rate of inflation exists that maximizes steady-state inflation. Conventional estimates of the seignorage-maximizing rate of inflation often make use of the Cagan form, which implies a constant semi-elasticity of money demand with inflation. The authors develop a model that implies a variable semi-elasticity. They show that the elasticity of substitution in transactions between money and bonds is a crucial determinant of the seignorage-maximizing inflation rate and of whether the semi-elasticity of money demand with inflation increases with inflation. Individual country estimates and cross-country panel regressions based on annual data from 11 high-inflation countries provide empirical support for their model. Relaxing the hypothesis of a constant semi-elasticity leads to estimates showing that, on average, the semi-elasticity of money demand with inflation increases with inflation. The results imply well-behaved Laffer curves that peak at plausible inflation rates; under Cagan form, there is no seignorage Laffer curve. In addition, the estimates basedon the correct measure of the opportunity cost of holding money contrast starkly with implausibly high Laffer-curve maxima obtained when using conventional but wrong measures of inflation.

Suggested Citation

  • Easterly, William & Mauro, Paolo & Schmidt-Hebbel, Klaus, 1992. "Money demand and seignorage - maximizing inflation," Policy Research Working Paper Series 1049, The World Bank.
  • Handle: RePEc:wbk:wbrwps:1049
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    References listed on IDEAS

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