Question

Analyze the potential change in the monetary base if the Government's budget deficit is financed by the issuance of government bonds and the majority of government bonds are purchased by commercial banks.

Answer 1

potential change in the monetary base if the Government's budget deficit is financed by the issuance of government bonds and the majority of government bonds are purchased by commercial banks.

When government spends more than it receives in taxes (deficit spends), the result is an increase of money in the private sector.

However the Treasury recaptures that amount of money on average by selling securities in the open market in order to maintain the balance in its general fund.

Thus the private sector gains in net financial wealth in the form of securities when the government deficit spends. In effect, the government pays for its deficit spending with securities rather than money.

Now if the demand for bank loans increases, as indicated by a rising funds interest rate, the central bank will purchase securities in the open market as needed to maintain control of that rate.

That converts securities into money without affecting net financial wealth, and increases the direct purchasing power (money) of the private sector.

If a country continuously realizes deficits on the overall balance, the country will eventually run out of reserve holdings and its currency may have to depreciate against foreign currencies. The Official Reserve Account may get depleted. But then it depends on its current exchange rate arrangement: the former statement, true for fixed-exchange rate regime, is not true under a pure flexible exchange rate regime. A net currency supply on the forex exchange market implies that the government is buying either gold or foreign exchange etc. thereby increasing the official Reserve account. This is unlikely under the hypothesis of government deficit. A country deficit calls for a demand of the country's value on the foreign exchange market, implying the country is selling its reserves.