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Money demand and seignorage - maximizing inflation

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

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.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1049.

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Date of creation: 30 Nov 1992
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Handle: RePEc:wbk:wbrwps:1049
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  1. Dornbusch, Rudiger & Fischer, Stanley, 1993. "Moderate Inflation," World Bank Economic Review, World Bank Group, vol. 7(1), pages 1-44, January.
  2. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
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  12. Carl E. Walsh, 1984. "Optimal Taxation by the Monetary Authority," NBER Working Papers 1375, National Bureau of Economic Research, Inc.
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  18. Arrau, Patricio & de Gregorio, Jose, 1991. "Financial innovation and money demand : theory and empirical implementation," Policy Research Working Paper Series 585, The World Bank.
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