Archive for the ‘Monetary Policy’ Category

Financing Government Deficits with Money

May 10, 2018 6 comments

In an earlier post, I described the budget constraint faced by the federal government. Here I want to point out how a deficit can lead to inflation. I will also indicate how the European Union (EU) and Greece are related to this discussion since there is an interesting difference between the U.S. and Greece regarding deficits and inflation.

Financing Deficits by the Central Bank

Suppose that the government has a deficit meaning that its spending for all purposes exceeds its tax revenue and that the government is unwilling to raise tax rates and/or cut spending. Now imagine that lenders will not lend to the government by buying the bonds that the government has tried to sell. In this situation, one financing option (bond sales to the public) for deficits is unavailable.  If nothing else is done to deal with the deficit, the government simply runs out of money and must shut down its operations until new tax money arises. But there is another option in the U.S. and many other countries; the central bank (the Federal Reserve in the U.S.) can buy the bonds sold by the government.

To see how this works, consider what the Fed can do. The government sells the bonds sold by the government and creates bank reserves as a result. Bank reserves would just be deposits at the Fed owned by banks. Those bank reserves will expand the money stock and so we have the Fed “printing” money to finance the government’s deficit. But to paraphrase the late Milton Friedman, inflation is a monetary phenomenon. Thus the government’s deficit can be accompanied by inflation. This appears to be happening now in the socialist paradise of Venezuela. But for Greece the situation is different because of its membership in the European Union (EU). Read more…


The Government Budget Constraint

May 3, 2018 1 comment

My last post reported on the latest Congressional Budget Office (CBO) analysis of the federal government budget showing unprecedented increases in the ratio of government debt to GDP. That ratio emerges from the government’s budget constraint which is the topic addressed here.

The Government Budget Constraint

The government’s sources and uses of funds are collected together into one expression, known as the Government Budget Constraint, which states that the sources of funds must equal the uses of funds by the government. The table below lists these items.

Uses of Funds Sources of Funds
Spending on Goods and Services Tax Revenue
Interest Payments Government Bond Issue
Net Transfer Payments

The uses of funds include spending on goods and services, interest payments, and net transfer payments to the public. This latter category includes, among other things, the Social Security and Medicare programs. So Net Transfer Payments rise as the entitlements crisis unfolds. If interest rates on government debt rise, interest payments by the government must rise as well.

On the sources side of the ledger, the government gets tax revenue which it uses to pay for its spending and/or it may issue government bonds to pay for spending if its spending exceeds its tax revenue. So the CBO report said that the government will be running deficits increasing in size into the future and thus will have to issue increasing amounts of government debt to finance its spending.

But this table does not include the role of the Federal Reserve which is included in a related concept which we discuss now. Read more…

The Government Deficit and the Fed

April 13, 2017 2 comments

The Federal Reserve recently announced an increase in the interest rate which it sets. This has implications for the government deficit which may not be well understood by the average person so I thought that it might make sense to discuss the connection between the Federal Reserve and the government deficit. What this discussion reveals is that the Fed has been helping to finance the government deficit in the U.S.

The Consolidated Government Budget Constraint

There is a relationship between the government and the Fed known as the Consolidated Government Budget Constraint that is written below.

Spending + Interest Payments + Net Transfer Payments =

Tax Receipts + Change in the Stock of Debt + Change in the Monetary Base

The items on the left side of the equal sign are the uses of the government’s funds. Spending refers to the fact that the government buys goods and services, it makes interest payments to the holders of government debt, and it makes transfer payments to individuals in the economy. The right side of the equation is the list of sources for the government’s spending. It receives tax payments, it issues or retires bonds, and the last item reflects bond purchases or sales by the Federal Reserve. It is these last two items that reflect the connection between the Fed and the government deficit. Read more…

Gasp!!!: An Example of Good Economic Policy by the House

July 30, 2014 3 comments

I know – you are wondering if there is a misprint in the title. While I have been a frequent critic of economic policy by the government, I am here to write about an example of good behavior by the House of Representatives. Specifically, a bill has been introduced (read BILLS-113-hr5018-10-pages) which would require a policy rule to be used by the Fed as it conducts monetary policy.

Economists have devoted a great deal of research to the study of rules-based policymaking by the monetary authorities. Here is an example of a rule that might be used.

i = π + .5·(Y – YP)/YP + .5·(π – 2) + 2

In the above equation, i is the interest rate controlled by the Fed (such as the Federal Funds rate), π is the inflation rate, and YP is the level of real output at full employment. There are a number of advantages to using this rule. Read more…

A Trillion Dollar Coin

January 10, 2013 Leave a comment

A new economics story making the rounds of blogs and even coming up at a White House press conference is the idea that the government could mint a trillion dollar platinum coin, thus circumventing the need to engage in any contentious debt ceiling negotiations. Indeed, this is such a hot topic that I was confronted with this possibility by the guys at the gym where I exercise (these guys know I am an economist and so I get to answer every economics question that occurs to them).  Here is the answer that I gave them.

We operate what is known as a fiat money monetary system. The coin and currency which we all use and carry around in our pockets is money because the government says that it is money. The value of the goods and services bought by a piece of paper currency is much greater than the cost of producing that piece of paper.

The coin-printing story seems to have originated on some left-wing blogs (see this New York Times article) where the originator(s) came up with the bright idea that printing a coin eliminates the need to argue over the debt ceiling. The fact that a government can print money to cover a government deficit is not news to economists (it is well known to economists that it has been done by governments in the past). But my reaction to these bloggers is that they probably do not realize that if the U.S. were to do this, two things would now be true.

One is that the U.S. would be making a public statement that it has now degraded itself to the status of a banana republic where the government prints money because it cannot or will not raise tax revenue to pay for its spending.

Second, if the government were to do this (and there seems to be no serious chance that it will), the U.S. will experience an enormous inflation in the prices of all goods and services produced in its economy. In fact, to continually print money would ultimately lead to a hyperinflation (defined to be an enormously hight inflation rate) and, eventually, people would no longer use money for economic transactions. People would revert to barter. This would generate a staggering loss of economic welfare.

My guess is that the bloggers who came up with what they thought was a bright and clever idea have no clue about the damage that could be done to the U.S. if their idea were actually the policy of the U.S. government. Fortunately, even the politicians in this country seem to know that we should not be printing money to cover government deficits. At least I hope they know.

Anna Schwartz, 1915 – 2012

September 10, 2012 Leave a comment

Anna Schwartz was an economist who was not well known to the public. Ironically, Schwartz, who recently died (the New York Times has provided an excellent obituary), was a coauthor of one of the most important scholarly studies ever produced by the economics profession.

Schwartz, along with her coauthor the late Milton Friedman, produced the treatise A Monetary History of the United States. This scholarly work, published in 1963, provided what to this day is the basic framework for our understanding of the banking system and its interaction with central banks. But more importantly, Friedman and Schwartz provided the explanation for the origin of the Great Depression, the single event which gave rise to the discipline of macroeconomics, the area of study within the social science of economics which tries to explain, among other things, the origins of business cycles.

It would be hard to overstate the importance of this research because it provided the explanation of what caused the most traumatic cyclical event in U.S. economic history, a contraction so severe that the U.S. unemployment rate rose to nearly twenty five percent of the work force. Friedman and Schwartz convincingly documented the actions taken by the Federal Reserve which caused a recession to deteriorate into the Great Depression. Their explanation of the cause of the Depression has never been seriously challenged by subsequent economic research and thus remains today as the economics profession’s explanation of the Depression.

More positively, the research of Friedman and Schwartz gives us good reasons to think that the world will never again experience another extreme cyclical contraction. The most recent U.S. recession, beginning in December 2007 and ending in June 2009, could easily have been turned into another Depression if the Federal Reserve had made the same mistakes that it did in the early 1930s. But the proper course of action to be taken by a central bank in recessions is now well understood and the Fed followed the proper course of action to mitigate the recession. While there have been critics of some Fed actions associated with this recession, there is wide agreement among economists that the Fed was right to expand the U.S. money stock in response to the recession which is precisely what the Fed did not do in the early 1930s.

Central banks around the world now know how they should set their policies in recessions and we have Friedman and Schwartz to thank for providing us with this knowledge.

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A blog by John B. Taylor

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