What is Seigniorage?
Seigniorage refers to the profit made by a government when it issues currency. It is simply the difference in the value of the currency versus the cost of producing it.
For example, if a central government bank produces a bill worth $10 and it only costs $5 to make it, there is a $5 seigniorage. In simpler terms, it is the difference between the face value of a currency and its production cost.
Seigniorage is a way for governments who mint their currency to make an economic profit. The cost of producing currency is generally lower than the face value of the currency itself. Additionally, central banks and governments also reinvest the difference between the currency’s face value and the cost to produce it to earn interest.
- Seigniorage is the difference between the face value of a currency and the cost to produce it.
- Central banks and governments earn profit through seigniorage and typically reinvest such profits to earn interest.
- Monetary seigniorage can be used as a monetary policy tool.
History of Seigniorage
Historically, seigniorage was the Crown’s right to a percentage of the bullion – gold or silver used to make coins – brought in to mint a coin. The right to a percent of the bullion was treated as a tax and thus, increased the cost of minting a coin that was paid for by the customer. The funds were then sent to a sovereign. Additionally, it was used as a prerogative by a feudal or sovereign superior.
Furthermore, coins were not made purely with gold or silver. Base metals were mixed with gold and silver to make the coin more durable. It allowed the coin smith to take a percentage of the gold or silver provided for the coin-making, as the base metal was cheaper than the gold or silver. An example is the British pound sterling – it was 92.5% silver.
Seigniorage and Central Banks
Central banks provide banknotes at face value to people through financial institutions. Financial institutions will typically pay for the notes through electronic transfers to the central bank. For example, the Royal Bank of Canada (RBC) receives notes from the Bank of Canada and electronically transfers the value of the notes to the Bank of Canada.
Once a central bank receives the electronic funds for the banknotes, they will invest them into government or sovereign-issued securities, which are typically treasury bills and bonds. Thus, the central bank is also able to earn interest on these investments while also earning seigniorage on the sale of the note itself.
Monetary seigniorage is when a party exchanges government or sovereign-issued securities for new banknotes from the central bank. In effect, the central bank or sovereign is borrowing without repaying. It is similar to the concept of quantitative easing, which is where central banks will buy back government bonds or other financial instruments to increase the money supply and inject money to expand economic activity. Governments typically use quantitative easing when facing an economic downturn or simply want to increase the economic activity of their nation.
Monetary Seigniorage and Monetary Policy
Monetary seigniorage can be used as an effective monetary policy tool. It can result in debt monetization. Debt monetization is when a central bank will buy interest-bearing debt with non-interest-bearing money. It can be a useful tool to control the debt level of an economy.
Furthermore, monetary seigniorage can be used to control interest rates. When a central bank exchanges newly printed banknotes for financial assets, they inject money into the economy. By increasing the money supply in an economy, market interest rates decrease. The overall goal is to increase economic activity.
However, a criticism of this is that the money does not always end up in the hands of the general population. When financial assets are bought or borrowed by central banks, they are typically presented in large amounts. Thus, central banks conduct the transactions with large financial institutions, which are not obligated to inject the money they received to sell their financial assets into the economy.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To keep learning, the following readings will be helpful: