Seigniorage
Seigniorage, also spelled seignorage or seigneurage, is the net revenue derived from the issuing of currency. It arises from the difference between the face value of a coin or bank note and the cost of producing, distributing and eventually retiring it from circulation. Seigniorage is an important source of revenue for some national banks.
How it works
It works because physical currency (bills and coins) does not collect interest: it is an interest-free loan to the government.
To simplify, imagine that money is backed by gold and that this is how you normally acquire or redeem it. Thus if one dollar is backed by one gram of gold you can buy dollar bills from the government and later redeem them. So if you buy a one dollar bill with one gram of gold, put the bill under your bed and a year later redeem it, you have loaned the government one gram of gold for one year at no interest. This is seigniorage.
Even if you then use the bill to buy something, someone is holding the bill for the entire time and the government still has the gold.
Pithily, seignorage is the carry on money in circulation.
Further discussion
Ordinarily seigniorage is only an interest-free loan to the issuer because when the currency is worn out the issuer buys it back at face value thereby negating the revenue earned when it was put into circulation. Currently under the rules governing monetary operations of major central banks, seigniorage on bank notes is simply defined as the interest payments received by central banks on the total amount of currency issued. However if the currency is collected instead of being returned to the issuer the back end of the deal never occurs.
For example: the "50 State" series of quarters (25-cent coins) was launched in the U.S. in the late 1990s based on the Millennium quarter series in Canada. The U.S. government planned on a large number of people collecting each new quarter as it rolled out of the U.S. Mint thus taking the pieces out of circulation. Since it costs the Mint less than five cents for each 25-cent piece it produces the government made a profit whenever someone "bought" a coin and chose not to spend it. The U.S. Treasury estimates that it has earned about $5 billion in seigniorage revenue from the quarters so far. (http://www.cbo.gov/ftpdocs/62xx/doc6271/hr902.pdf page 5) (April 2005).
The introduction of €500 and €200 Euro notes is seen as a source of Seigniorage revenue for the European Central Bank, particularly because no other major central bank issues currency in such large denominations.[1]
Seigniorage can be seen as a form of tax levied on the holders of a currency and as such a redistribution of real resources to the issuer. The expansion of the money supply causes inflation. This means that the real wealth of people who hold cash or deposits decreases and the wealth of the issuer of the money increases. This is a redistribution of wealth from the people to the issuers of newly-created money (mostly banks) very similar to a tax.
This is one reason offered in support of the creation of modern, independent, central banks whose primary objective is arguably to ensure the value of currency by controlling monetary expansion and thus limiting inflation. Independence from government is required to reach this aim - indeed, it is well known in economic literature that governments face a conflict of interest in this regard. In fact, "hard money" advocates argue that central banks have utterly failed to obtain the objective of a stable currency. Under the gold standard, for example, the price level in both England and the US remained relatively stable over literally hundreds of years, though with some protracted periods of deflation. Since the US Federal Reserve was formed in 1913 however, the US dollar has fallen to barely a twentieth of its former value through the consistently inflationary policies of the bank. Economists counter that deflation is hard to control once it sets in and its effects are much more damaging than modest, consistent inflation.
A seigniorage reform for the information age on a full-reserve banking base is proposed by Joseph Huber and James Robertson: Creating new money. The fruit of collaboration between a German academic and a British economic writer they argue for one reform: the reappropriation by governments of the right of seigniorage now possessed by private banks. About 95% of new money currently issued takes the form of loans made by private banks to their customers. Huber and Robertson want to make this illegal. The creation of new money, both cash and non-cash should be the exclusive prerogative of the central bank. The latter should determine how much it creates in the light of the objectives chosen for the country's monetary policy and credit the new money to the government who will then put it into circulation by spending it.
However, it is important to reiterate that banks or governments relying heavily on seigniorage and fractional reserve as a source of revenue will find it counterproductive. Rational expectations of inflation will begin to take into account the bank's seigniorage strategy leading to hyperinflation which causes significant real damage to the economy. Instead of cashing seigniorage from fiat money and credit most governments opt to raise revenue primarily by other means, generally taxation.