Financing of public sector debt

An increase in public sector debt therefore based on the above
analysis results in an increase in money supply. However, it must
be noted that the increase in public sector debt has to be financed.
It can be financed by:

(i) borrowing from the non-bank public by selling government
bonds to them. Non-bank public pays the government by
drawing down their deposits. End result, no change in
money supply.

(ii) borrowing from the commercial banks by selling
government bonds to them. If commercial banks had some
excess reserves, money supply will still increase. But if they
had no excess reserves, then money supply will fall.

(iii) borrow from the central bank ie. print money. The revenue
that a government raises by printing money is called
seignorage.(Any government that has the authority to
issue money can use seignorage).

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Public Sector Debt and the Money Supply

Public Sector Debt and the Money Supply

Public sector debt arises when there is an excess of government
spending over its receipts. If the debt or the budget deficit arises
because of an increase in government spending e.g. government
purchased something from the non-bank public, then the following
would have happened:

recipients of the payment from the government would have
deposited the money in their banks. An increase in D means
that M has increased;

The commercial bank will now claim the payment from the
government. There reserves increase, which therefore
results in a multiple expansion of bank deposits.

Fixed exchange rate 2

A balance of payment deficit on the other hand, results in an
excess demand for foreign currency. To prevent the domestic
currency from depreciating, the central bank intervenes by selling
foreign currency in the foreign currency market. This reduces the
central bank’s reserves of foreign currency and also the money
supply in the country as the domestic currency in now no longer in
the domestic market.

Under a fixed exchange rate system, the money supply equation
becomes:

Ms = m x (Hd + Hf)
where: Hd is the domestic component of high-powered money
Hf is the foreign component (include gold, foreign
currencies)

The central banks has control over Hd but not Hf as the latter
depends on the external surplus or deficit.

Fixed exchange Rate

Fixed exchange Rate:

When a country is on a fixed exchange rate system, on the other
hand, a balance of payment surplus or deficit will result in a change
in the domestic money supply.

Starting off again with a balance of payment surplus, the excess
supply of domestic currency (or excess demand for domestic
currency) would have resulted in an appreciation of the domestic
currency. To keep the exchange rate fixed, the central bank will
intervene and it will buy foreign currency . This increases the
central banks’ reserves of foreign currency. Money supply in the
country likewise increases as more domestic currency is placed on
the market.

Money supply in an open economy

Money supply in an open economy

So far our discussion is based on a closed economy.
In an open economy the domestic money supply can be affected
depending on the type of exchange rate system the country
is on.

Flexible Exchange rate system
Under a flexible exchange rate system, the country’s balance of
payment will always balance. Should the country experience a
balance of payment surplus for example or a situation of an
an excess supply of foreign currency (or an excess demand for
domestic currency), the domestic currency will appreciate vis-à-vis
the foreign currency. The appreciation makes domestic goods more
expensive and imported goods cheaper resulting in a decline in
domestic X and an increase in imports.

In a flexible exchange rate
ssystem, a surplus in the balance of payment results in an
appreciation of the domestic currency which then eliminates the
surplus. Vice versa had we started off with a balance of payment
deficit , the excess demand for foreign currency (or excess supply
of domestic currency) would have resulted in a depreciation of the
domestic currency vis-à-vis the foreign currency.

This now makes domestic goods cheaper relative to imports. The increase in net
exports therefore reduces the deficit in the balance of payment.
Since the balance of payment always balances through the
adjustments in the exchange rate, there will be no effect on the
domestic money supply.

Determinants of the reserve-deposit ratio

Determinants of the reserve-deposit ratio:

Regulatory requirements: An increase in the required
reserve ratio will increase the reserve-deposit ratio.

Increase in the discount rate: Makes it more expensive for
commercial banks to borrow from the central bank should
there reserves be insufficient.

Market interest rate: An increase in market interest rate
increases the opportunity cost of holding excess reserves
and therefore reduces the reserve-deposit ratio.

Business cycle : rr tends to rise during recessions as banks
tend to view loans as very risky and therefore are more
incline to hold more excess reserves.

Average variability of deposit flows: When there is an
increase in the average variability of deposit flows, banks
require a greater cushion against outflows and tend to
increase their reserve-deposit ratio.
From the above we can see that contrary to the vertical money
supply curve we assumed before, money supply is now positively
related to interest rate.

From the above we can see that contrary to the vertical money
supply curve we assumed before, money supply is now positively
related to interest rate.