Central Bank Independence in Transition Economies

Central Bank Independence… 

S&A No. 120 

7

value of other nominally-denominated assets, including Government liabilities (Barro 

and Gordon 1983a). In particular, the inflationary surprise depreciates the interest 

bearing debt fixed in nominal terms and reduces Government's future real expenditures 

for interest and repayment of principal. 

As long as it is not anticipated by the people, the seignorage is an unexpected 

capital levy. The Government imposes this tax once people have optimally decided 

what amount of real resources they want to hold. Thus the theoretical advantage of the 

seignorage over other form of taxation is that it is non-distorting, at least ex-ante (the 

distortions arises when people anticipate the imposition of the inflationary tax). In 

practice, the degree of reliance on the seignorage revenue seem to be determined not 

by the optimal taxation motives but mainly by the efficiency of the tax system. Thus 

the Government relies on the inflationary tax if other taxes are difficult to collect. The 

seignorage revenue is easily and immediately transferred to the Government if it is 

allowed to borrow directly from the Central Bank. Even if this privilege is restricted or 

prohibited by law, the legal protection does not have to be binding due to poor 

compliance with the law (Cukierman 1992, p. 47). This situation is particularly 

plausible in countries where the Government faces constraints on borrowing from 

private agents, e.g., when financial markets are too narrow. In this case “printing 

money” may be the only possible source of deficit financing. 

The revenue motive may account for the hyperinflationary episodes which are 

impossible to explained by the employment motive. The higher money growth 

decreases tax base (through higher inflationary expectations) but increases tax rate. It 

can be shown (Cagan 1956) that the seignorage revenues initially rise with the 

monetary expansion, reach a maximum and then decrease. Empirical studies (Cagan 

1956) indicate that in hyperinflationary episodes the money growth was excessive i.e., 

seignorage revenue was lower than could be if the money growth was decreased. 

Cagan (1956) explains this phenomena by lagging inflationary expectations of the 

private agents and strong positive time-preference of the policymakers. Barro (1983) 

presents another explanation, based on the time-inconsistency of optimal policy. He 

shows that the excessive money growth is possible if the Government places much 

greater weight to the seignorage revenue than to the inflation cost in its loss function.