Question

i) How might a central bank use monetary financing to allow the government to run up a bigger budget deficit?

Answer 1

Central bank financing of fiscal deficits is not a new phenomenon in both developing and advanced economies, however, it has assumed importance particularly in the aftermath of the recent global financial crisis. This is more pronounced on the back of increasing government debts and reduced tax revenues. Generally, financing budget deficit can take a number of forms: reduction in expenditures, increasing fiscal revenues, printing money or by borrowing from domestic and external sources. Each of these mechanisms carry different trade offs that policy makers have to always bear in mind. In some countries, there are provisions governing the amount of central bank financing. A brief review of the experiences of developing countries with central bank financing of deficits is varied. For instance, in Costa Rica, central bank finances 5% of government expenditure and 25% of the national budget. In Bahrain, the maximum amount that can be borrowed is left open to negotiations between the central bank and the Minister of Finance. The implication is that where countries have lax laws, central banks are allowed to provide advances to the government and this is a common feature in many developing countries, especially those with shallow tax base and undeveloped financial systems.

The varied experience of developing and developed countries with central bank financing of deficits reflects the different economic and historical experiences. It equally highlights the important role of deficit financing since large and persistent budget deficits may jeopardize macroeconomic stabilization as they by far determine most of the macroeconomic indicators including but not limited to growth, inflation and interest rates. Continual financing of fiscal deficits by central banks may thus undermine their operational autonomy.