When the Government’s expenditure can’t be met with the revenue it generates then, it leads to a budget deficit. And, to finance budget deficits, Government borrows money. Government can meet its budget deficit through various means. One such option it has is through bonds.
We have already covered a bit about bonds: What is a bond?
But, investment in bonds does carry some risks. These risks include Credit risk, inflation risk, liquidity risk, etc. In the context of the article, Credit risk assumes greater importance. The Government can default on the interest or maturity payments. And, when investors are wary of Credit risks they tend not to invest in bonds that the Government issues.
So, what conditions can make the investors believe that Government would default on its bond payments? Investors jitter when they realize that the Government debt has got to unsustainable levels.
There comes a time when investors are no longer interested in investing in Government bonds and still, the Government has to finance the deficit. So, it turns to the central bank.
The central bank can just print money to finance the government deficit. And, it purchases Government bonds. And, this leads to Seigniorage.
What is Seigniorage?
Seigniorage = Face value of money – Cost of producing money
It is counted as Seigniorage revenue when it is positive for the Government i.e. the face value of money is higher than its costs. In that case, the Government can finance its budget deficit.
The term comes from seigneurs, a feudal title in France. The seigneurs could just mint coins. It is worth mentioning here that, the term isn’t entirely related to Government financing its budget deficits.
When your bank borrows from a central bank then it provides a steady stream of income i.e. interest income for the central bank. We can say the central bank is earning Seigniorage income.
It is worth mentioning here that when Government finances its budget deficit through bond borrowing. Then, it pushes the interest rates up and hurts economic growth.
