Assume that a central bank's nominal seigniorage revenue equals the change in the money supply, denoted ?M. Real seigniorage revenue is ?M/P. Assume the inflation rate equals the growth rate of the money supply, which is ?M/M.
a. What is the rationale for these assumptions? Are they realistic?
b. Write real seigniorage revenue in terms of the inflation rate and the real money supply, M/P.
c. When inflation rises, what happens to the real money supply and to seigniorage revenue?
d. Sometimes a small increase in the government budget deficit produces a large increase in inflation. Explain this fact using the answer to part (c).