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Expression (3) indicates that the amount of resources that could be mobilized though money creation depends on three factors - the rate of inflation, the growth of the economy, and people's willingness to hold real money balances. If the demand for real balances were invariant with respect to inflation, the government could in principle mobilize large amounts of resources though money creation. The problem, however, is that empirical evidence shows that the demand for real money balances is a negative function of inflation and this sensitivity increases with the pace of inflation. So, other things remaining unchanged, more money creation would cause a more rapid pace of inflation which will reduce the demand for real money balances. Therefore, the impact of inflation on seignorage will depend upon the relative strengths of the two opposing forces--with high inflation the inflation tax rate (sr) goes up, but the tax base (MIP) falls.1<sup>0</sup> 27. Let us now apply these concepts to Pakistan's case. Table 13 shows the government's total debt, interest payments, primary deficit and seignorage, all expressed as a percentage of GDP. A number of important points should be noted. First, in calculating domestic debt, the Government's obligations to the State Bank of Pakistan (SBP) are excluded as these are simply the counterpart of a large component of the seignorage. Second, it is assumed that the Government does not pay interest on the SBP's holding of T-bills. Examination of the SBP profit and loss accounts suggest this is a reasonable assumption. Third, seignorage revenues are broken down by the actual beneficiaries. A significant share of the seignorage revenues are returned back to the private sector through SBP rediscounts to commercial bank at below market rates." The profile of total debt shows the same pattern as external debt, declining upto 1981 and then a large increase to over 84% of GDP by 1991. Decomposing the change in total debt-GDP ratio into its determinants yields the following results (see Table 14).

- Pakistan ran large budget deficits between 1973 and 1981; other things rening unchanged, the associated primary deficits would alone have added 77 percentage points to the total debt-GDP ratio over the period. The effect of these large deficits was, however, more than offset by a combination of revenues from seignorage, negative interest rates, rapid economic growth and an appreciation of the real exchange rate. So, despite large fiscal deficits, the total debt-GDP ratio actually declined.

During 1981-1991, the total debt-GDP ratio changed gear and grew rapidly, expanding by 38 percentage points over the period. What caused this worsening? First, of course, was the role of fiscal deficits-although primary deficits were lower on average than during the previous decade, they remained significantly large. In fact, other things remaining unchanged, pnmary deficits alone would have added 52 percentage points to the total debt-GDP ratio. A second factor that added to the debt-

- D This relationship between inflation and seignorage tkes the form of a bell-shaped curve. Seignorage initially ises with inflation, then reaches a uaximum **before** declining. The classic work is due to Cagan (1956). also modified by Friedman (1971) to **bring in the** role of income growdt in seignorage, and by Bailey (1962) to show the impact of **welfare** costs of inflation. Friedman's modification **is** especiaUy important for low inflationi countries, where higher economic growth by itself will yield non-inflationary means of budget financing through moderate money creation.

- The correct definition of seignorage revenues **for the** Treasury requires **one** further adjusrmenL **Iterest earned** by SBP on **the rediscounts** kss interest paid by SBP on comnercial bank required reserves should be added back. **Unavailabiliy** of the required **data** presented this adjusbuent.