Borrowing From the Central Bank

In other words borrowing from the central bank is called “monetizing” the deficit. Because this method always leads to the growth of monetary base and of money supply, it is often referred to as just “printing money”. As can readily be seen from equation (2), here increase in the high-powered money is the source of financing budget deficit.

Monetization occurs (i) when the central bank directly finances budget deficit by lending funds needed to pay government bills; or (ii) when the central bank purchases government debt at the time of issuance or later in the course of open market operations.

If the central bank just lends funds or purchases newly issued government debt, it simply pushes up the stock of high-powered money. It may also be the case that the government first borrows from public or from commercial banking system. However, if the central bank then intervenes and either buys out the debt from the public by means of open market operations or accommodates additional demand for liquidity from banking system, the equivalent amount of reserves gets injected into the economy as if the government originally borrowed from the central bank. In either case budget deficit (DEF) is financed, as can be seen from equation above, by increases in high-powered money.

Let us now assume that the government for some reasons can borrow only from the central bank (it has lost the public’s confidence and foreign exchange reserves are near the critical level). Then our budget deficit financing equation will look like:

(3)

If we follow the assumptions of Sachs and Larrain (1993) that Purchasing Power Parity (PPP), as well as quantity theory of money hold, then, under a fixed exchange rate regime, one reaches the following conclusion: even if government tries to borrow from the central bank, and it starts printing money, the bank in effect is running down already depleted foreign exchange reserves, because it has to intervene in foreign exchange market to maintain the fixed exchange rate. This in turn will lead to a reversal of the money supply increase, i.e. ultimately will hold. Although the money supply seems not to have grown much, the resulting upward pressure on exchange rate, stemming from persistent need of financing and entire foreign exchange reserves exhaustion, may end up in currency devaluation, which would then greatly increase inflation.

Under a floating exchange rate regime the outcome is different. Let’s now distinguish the nominal (DEF) from real (DEFr) value of budget deficit so that . We also assume that the government cannot borrow from public and foreign exchange reserves are zero. For simplicity of presentation, we may approximate the change in high-powered money by the change in money supply (because we know the rapid change in the former necessarily causes the change in latter). Consequently, our equation (3) becomes .

In other words, the real value of the deficit is now equal to the real value of the change in money supply. The budget deficit in such a situation is said to be financed by collecting seigniorage. In Dornbusch and Fischer’s words (1998), seigniorage refers to “the government’s ability to raise revenue through its right to create money”. The amount of seigniorage (S) is then given by the expression: . If we rearrange components in this formula and introduce percentage growth in nominal money supply and real money balances , then we obtain that .

Interestingly, the amount of seigniorage can usefully be decomposed into the “pure seigniorage” and “inflation tax” part. It can be shown[4] that:

. If we denote the inflation rate as , then we would have: . The first term is referred to as “pure seigniorage” and represents the change in real balances. The second term is called “inflation tax” with being a tax rate and being a tax base.

In the words of Dornbusch and Fischer (1998), “inflation acts just like a tax because people are forced to spend less than their income and pay the difference to the government in exchange for extra money. The government thus can spend more resources, and the public less, just as if the government had raised taxes to finance extra spending”. When government finances a deficit by printing money, there are good reasons to believe that the public seeks to maintain real balances so as to offset the effects of inflation. The public therefore chooses to hold more and more nominal money from period to period, so as to keep real balances and thus purchasing power constant in the long run. If this is the case, then , i.e. the government collects no pure seigniorage, but rather finances the budget deficit entirely through the inflation tax.

Thus, we may conclude that under a pure floating exchange rate regime, budget deficit ends up in inflation and, as shown above, the size of the deficit and inflation rate are very closely connected. According to the formula, higher deficits entail higher inflation rates (Sachs and Larrain, 1993).

In passing we should note the implication that macroeconomic theory derives about financing a budget deficit through inflation tax: a sustained increase in money growth and in inflation ultimately leads to a reduction in the real money stock (Dornbusch and Fischer 1998). With respect to transition economies, the rationale behind such an implication may be that public adjusts to the higher inflation by switching from heavily taxed domestic currency to a different hard and stable currency (e.g. U.S. dollar).

So far we have basically considered the most essential mechanisms of financing a budget deficit. However, one additional strong statement that seems appropriate and relevant here should be made. A sustained inflation may stem only from a persistent rather than a temporary budget deficit that is eventually financed by printing money rather than by borrowing from public (Mishkin, 2000).

Date: 2015-02-28; view: 992