Introduction to Seigniorage

When economists talk about increasing the supply of money in an economy, they are not necessarily referring to the creation of new physical currency.  In fact, only about 10 percent of what is commonly considered the money supply in the United States takes the form of actual, well, what we would think of as money.  (The rest exists as deposits in various highly liquid types of bank accounts.)  In some ways, having only a small fraction of the money supply exist as currency is very efficient, since minting coins and printing paper money isn't free.

 (In other words, this is one case where the phrase "it takes money to make money" is literally true!)

Seignoriorage (sometimes also spelled "seignorage") refers to the net revenue (or, perhaps more accurately, profit) that a government makes from creating physical currency.  In its simplest form, seignoriage is the difference between the value of the currency created and the cost to physically produce that currency.  For example, the government seigniorage from printing a dollar is about 95 cents, since it costs about 5 cents to print a dollar bill.  (Not surprisingly, the fraction of a currency's value that goes to creation cost decreases as the denomination of the currency increases.)

In some cases, seigniorage can even be negative, meaning that it costs more to produce a unit of currency than that unit of currency is, by definition, worth.  For example, it costs between 1 and 2 cents (depending on the price of zinc) to create a penny, which is of course worth 1 cent.

 This means that the government actually gets some fraction of a cent poorer every time it mints a penny.  (This probably also explains why we don't see many penny counterfeiters.)

In economies that use commodity-backed money (e.g. are on the gold standard), seigniorage can be thought of as the profit from being able to borrow interest free from the public.

 This is because a government receives goods and services in return for the printed money, but it must accept the money in return for some commodity only at some future time. It gains further if issuing new money reduces (through inflation) the value of old money by reducing the liability that the old money represents.  (Technically, this principle applies to fiat money as well, though it's not as intuitive since in these cases currency is just redeemed for other currency.  In such cases, the government never has to repay the debt in a literal sense.)

If it costs money to create currency but not to create money in deposit accounts, when and why does it makes sense to specifically create currency?  Obviously, there has to be some physical currency who want to pay for things in cash.  In addition, central banks and/or treasury departments sometimes find it useful to issue currency that people tend to collect or use as a store of value rather than circulate, since this can both create revenue and decrease the amount of money actually circulating.  Lastly, currency is often created to replace existing currency that has gotten work out or damaged.