Consider an economy in which the money supply consists of both currency and deposits. The growth rate of the monetary base, the growth rate of the money supply, inflation, and expected inflation are all constant at 10% per year. Output and the real interest rate are constant. Monetary data for this economy as of January 1, 2005, are as follows:
Currency in circulation...........................$200
Bank reserves....................................... 50
Monetary base..................................... 250
Deposits............................................. 600
Money supply....................................... 800
a. What is the nominal value of seignorage over the year? (How much monetary base is created during the year?)
b. Suppose that deposits and bank reserves pay no interest and that banks lend deposits not held as reserves at the market rate of interest. Who pays the inflation tax (measured in nominal terms), and how much do they pay? (The inflation tax paid by banks in this example is negative.)
c. Suppose that deposits pay a market rate of interest. Who pays the inflation tax, and how much do they pay?