Question

In the early 1980 s, Brazil's government, through an average inflation rate of 147 percent per year, got only 1.0 percent of output as seigniorage, while Sierra Leone's government got 2.4 percent through an inflation rate less than a third as high as Brazil's. Can you think of differences in financial structure that might partially explain this contrast? (Hint: In Sierra Leone, the ratio of currency to nominal output averaged 7.7 percent; in Brazil, it averaged only 1.4 percent.)

Short answer

Sierra Leone experienced greater seigniorage revenue with a lower inflation rate than Brazil because of a higher ratio of currency to nominal output (7.7% compared to Brazil's 1.4%), indicating a greater reliance on physical currency in its economy, likely due to differences in financial structures and the level of financial technological advancement.

Step-by-step solution

Understanding Seigniorage

Seigniorage is the profit made by a government by issuing currency, especially the difference between the face value of coins and their production costs. In this context, it represents the profit as a percentage of output (or nominal GDP) that a government earns from issuing its currency. Higher inflation can lead to higher seigniorage, but this relationship is also affected by the financial structure of an economy particularly, the proportion of currency in circulation relative to the total nominal output.

Recognizing the Role of Currency to Nominal Output Ratio

The currency to nominal output ratio indicates the amount of currency that is actually being used in the economy relative to its total output. A high ratio means that a significant portion of the economic transactions are conducted using the currency, which can result in higher seigniorage from the same rate of inflation. This is because more money being in circulation can increase the ability of the government to finance itself through money creation without causing immediate high levels of inflation.

Comparing Brazil and Sierra Leone

Brazil had a much lower currency to nominal output ratio (1.4%) compared to Sierra Leone (7.7%). This implies that, despite having a higher inflation rate, Brazil had less currency circulating in its economy relative to its output, which could reduce the effectiveness of seigniorage. On the other hand, even with a lower inflation rate, Sierra Leone had a higher currency to nominal output ratio, allowing it to gain a higher percentage of output as seigniorage.

Financial Structure and Seigniorage Revenue

Differences in financial structure, like the prevalence of alternative monetary instruments, banking penetration, and the level of cash usage in the economy, can explain the contrast between the two countries. Brazil might have a more developed financial system with a higher use of non-currency transaction methods, such as checks, debit cards, and credit, whereas Sierra Leone might depend more heavily on physical cash for transactions due to lesser development in financial services.

Key concepts

Financial Structure

The financial structure of a country is a key determinant of how monetary policy, including seigniorage, affects an economy. Financial structure refers to the mix of financial services, institutions, and instruments that exist within a country. It encompasses elements such as the banking system, stock markets, bond markets, and the use of cash versus electronic payments.

A country with a more sophisticated financial structure, like Brazil, might rely less on cash transactions, favoring electronic transfers, credit cards, or checks. As such, the demand for physical currency is lower, and so is the potential for earning seigniorage. This is because people and businesses are using non-cash forms of money that do not directly contribute to the seigniorage earnings of the government. Conversely, in Sierra Leone, where the financial structure may lean heavily on cash due to less developed financial services, the government can potentially earn more seigniorage at lower inflation rates because a large percentage of economic transactions require physical money.

Currency to Nominal Output Ratio

The currency to nominal output ratio is a crucial statistic that helps illuminate the role of currency within an economy. It is essentially the ratio of the amount of currency in circulation to the overall nominal output (GDP) of the economy. A higher currency to nominal output ratio suggests that a significant portion of the economy operates using cash.

In the case of Brazil and Sierra Leone, the lower currency to nominal output ratio in Brazil indicates that despite higher inflation, less currency is being used relative to the value of goods and services produced. This can affect the effectiveness of seigniorage as a tool for generating government revenue. Sierra Leone's higher ratio suggests more prevalent use of cash, which, when coupled with the creation of new money, allows for higher seigniorage revenue relative to its output, even with lower inflation rates.

Inflation and Government Revenue

Inflation can have a profound impact on government revenue, particularly through the mechanism of seigniorage. As prices increase due to inflation, governments can issue more currency without immediately increasing the cost to themselves, essentially 'taxing' holders of money as their purchasing power decreases.

However, this traditional relationship between inflation and government revenue has nuances. For instance, if inflation is too high, it can reduce the demand for currency, as people and businesses seek to protect their assets from losing value, often turning to foreign currencies or physical assets like real estate or commodities. This can decrease the effectiveness of seigniorage as a tool for raising revenue. On the other hand, moderate inflation in a cash-based economy can provide substantial revenue through seigniorage without causing rampant price increases that would erode trust in the currency.

Economic Transactions

Understanding the nature of economic transactions in a country gives insight into its currency usage and, consequently, its ability to generate revenue through seigniorage. Economic transactions include all exchanges of goods and services for money throughout an economy.

In countries where cash transactions predominate, such as Sierra Leone, the volume of currency physically changing hands during these transactions is high. This demands a greater supply of cash, hence, when new money is printed, it can be introduced into the economy without immediate inflationary effects, thus benefiting the government through seigniorage. In contrast, economies with a majority of non-cash transactions, as might be the case in Brazil, have less need for physical money, leading to a lower potential for seigniorage, since the creation of currency does not directly correspond to the majority of economic transactions.