Question

In a modern money economy, the money supply is composed of central bank issued currency and certain privately issued bank deposits that are convertible into currency on demand and can be transferred as payments electronically or by check. Thus, the stock of money is composed of both central bank notes (currency) and private bank debts (transaction or checkable deposits). There exists another class of government issued debts that are promises to pay fixed amounts of money at a specified time(s) in the future. Such government debts (treasury bills, notes, and bonds) are marketable and thus can be converted into "money" at any time. Thus, since such governmental debts can be easily converted into checkable deposits (currency equivalents), why are these debts not part of the money stock as well? Carefully explain.

Answer 1

Government debt or public debt is incurred when the governments need more money to finance their expenditure on various over heads . The governments’ especially in the developing economies , may resort to borrowing in such cases.

There are two ways for government borrowings-1. By selling in the open market, where existing money is used, people may resort to buying these securities by withdrawing money from their deposits there by causing a rise in liquidity which will be matched by a fall in liquid assets as money is removed from bank deposits

However if the government borrows from the central bank it spends money drawn on the bank increasing the spending power of commercial banks and there by enabling them to lend more if the government borrows from them by selling short term securities which are a part of liquid assets

A central bank may buy government bonds from a private sector to increase money supply this will increase investment ,expenditure and aggregate demand

However commercial banks have to keep a certain proportion of their liquid assets to total liabilities as reserves. It is important because customers believe that if there is cash to pay out all their deposits they would go ahead and transact with the bank.

Government securities are used as instruments to increase or reduce money supply. For example if the central bank wants to reduce bank loans it will sell government securities and the purchasers will draw down on their deposits to pay for such an issue. This will cause a fall in liquid assets of the commercial banks .

Hence government stock is not a part of the total money stock as it is only a quantitative tool available with the central bank of a country to control the bank credit and volume of money supply