Government finance with currency substitution

We analyze seigniorage in an overlapping-generations model where a friction induces a precautionary demand for a weaker currency. The friction, which is modeled as a transactions cost, is viewed as an inverse measure of currency substitutability. Governments finance spending with costly income taxation or seigniorage. We show that if governments act independently, money growth is suboptimally low if currencies are sufficiently substitutable and too high otherwise. If money growth is suboptimally low, increasing substitutability lowers it further. However, since greater substitutability is associated with smaller real costs of exchanging money, welfare need not fall. (C) 1998 Elsevier Science BN.