Seigniorage results because the face value of paper bills and metal coins exceeds the cost incurred by government in their production. For example, the cost of producing a one-dollar bill is less than five cents, generating a seigniorage of 95 cents on each bill produced. In that the cost of producing larger denominations is about the same, the seigniorage of larger bills is obviously even more. Even the one-cent penny generates about three-tenths of a cent seigniorage.
The King of CoinsSeigniorage can be traced back to at least medieval Europe. During this era, gold was the medium of exchange and the minting of metal coins was the exclusive domain of the royal rulers (Kings and Queens). Gold was brought to the royal mints in bulk or bullion form and the royal mints transformed the bullion into coins. Of course, a royal fee was tacked onto this operation. This was the seigniorage.
This fee was termed "seigniorage" as an extension of the word "seignior," which was commonly used in reference to a feudal lord or ruler. In fact, this root word is also related to other common words including "senior," "senate," "sir," and "senile." There may be a common theme at work here.
Fiat ProfitAs modern economies moved from commodity (gold) to fiat money (paper currency), seigniorage also evolved. Rather than an extra fee charged for coin production, seigniorage now arises due to the difference between the face value of the money and the cost of production.
In fact, the modern use of fiat money, money with value in exchange but little or no value in use, is ideally suited to seigniorage. Rather than adding seigniorage profit onto the production of commodity money, the production of fiat money automatically generates seigniorage. By definition, the face value (value in exchange) of fiat money is greater than the cost of production (value in use). Seigniorage is unavoidable.
A Tax on Currency?Seigniorage is considered a tax on those who hold or "buy" currency. While this was clearly the case for commodity money, the "seigniorage tax" on fiat money is not as clear cut. The seigniorage of commodity money involved an extra payment to the royal rulers for transforming bulk metal into coins. A hundred pounds of gold was brought to the royal mint, but perhaps only ninety-nine pounds of coins were produced. The royal rulers would have then kept one pound of gold for seigniorage. This was clearly a tax.
In contrast, the production of fiat money means that something of greater value is generated from something of lesser value. Government does not remove money or value from the economy as royal coin makers did with commodity money.
Of course, to the extent that seigniorage adds revenue to the government treasury, then fewer taxes need be collected to finance government expenditures. In this sense seigniorage can be thought of as a tax.
Inflation Run AmuckHowever, the primary seigniorage tax of fiat money is really an "inflation tax."
Inflation, an increase in the average price level of the economy, reduces the purchasing power of money. If prices are higher, then money buys less. A primary cause of inflation is the amount of money circulating through the economy. More money means higher prices. More money means inflation.
Because government produces money and introduces it into the economy, it can spend the money BEFORE prices rise. However, when the money is spent, after it is introduced into the economy, THEN inflation arises. That is, government gets to spend the money when first produced, when it is more valuable, when prices are low. But the rest of the economy spends the money when it is less valuable, AFTER prices have risen. This loss of purchasing power is the inflation tax.
While seigniorage and any inflation tax that might result is generally not a major issue in modern economies, it can be problematic if government abuses its authority to print and mint currency. In particular, if government relies on seigniorage as a major source of revenue, then it is likely to accelerate the currency production process, which accelerates inflation. The result can be, and has been, hyperinflation--exceedingly high rates of inflation.
SEIGNIORAGE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2021. [Accessed: March 7, 2021].