European Central Bank working paper links convenience yields on government bonds to price level determination in a currency union

The European Central Bank published Working Paper No 3183 by Sebastian Schmidt examining price level determination in a currency union when some member states’ government securities earn a “convenience yield” and thus generate fiscal seigniorage. The paper argues that, alongside primary surpluses and monetary seigniorage, these fiscal seigniorage revenues can back the union’s price level and support a uniquely determined price level under an appropriate monetary-fiscal policy configuration, including cases where primary balances are permanently negative provided their present value is smaller than the present value of seigniorage. Using a tractable two-country model in which only one country’s bonds provide non-pecuniary liquidity and safety benefits, equilibrium links the real value of total union public sector liabilities to the present value of primary surpluses plus seigniorage from reserves and convenience-yield bonds. The analysis finds that an exogenous fall in private demand for convenience assets reduces convenience yields and the present value of seigniorage, pushing the price level up and producing cross-country wealth transfers because the issuer of convenience-yield bonds experiences a larger seigniorage decline; heterogeneity in convenience yields can also tilt wealth toward the issuer if seigniorage finances lower domestic taxes. In additional scenarios, asymmetric fiscal expansions raise the price level and shift consumption across countries, with convenience assets dampening household-level redistribution, while a move to permanent deficits in both countries can bind a lower bound on nominal rates and, in the model, prevent the central bank from achieving its inflation target, resulting in persistently higher inflation.