Borrowing From the Public

Borrowing from the public can be exercised either domestically or internationally.

The ultimate domestic purchasers of government debt, as pointed out by Ouanes and Thakur (1997), could be: (i) non-bank public; or (ii) banks. The essential difference comes from the likely impact of the operation on money supply and inflation.

· If the government debt is acquired by non-bank domestic public and then the government immediately spends the proceeds by paying its bills, then monetary base remains unchanged, there is no influence on money supply and therefore no room for inflation. Still, borrowing from public by issuing debt might cause certain inconveniences for policymakers. For example, bond finance of budget deficit may push up interest rates thereby putting pressure on private sector finance and on economic growth. Additionally, the cost of borrowing at such high rates surely increases debt service payments thus adding to future budget expenditures[5].

· If banks acquire the government debt, the consequences with respect to monetary base and money supply may differ. No doubt, government borrowing puts additional pressure on banks' reserves and banks may demand more liquidity from the central bank. If such an extra demand for credit from banks is accommodated and the central bank supplies banks with additional reserves, then in fact monetary base increases, thereby causing a rise in money supply through deposit multiplication and thus fueling inflation. However, if the central bank does not accommodate the extra demand, banks will be forced to reduce credit to the private sector in order to meet the higher demand for government credit by purchasing debt (Ouanes and Thakur, 1997). This reduction is often referred to as crowding out of private spending.

The impact of budget deficit on money supply when government borrows from foreign public crucially depends on the exchange rate regime.

· If the central bank adheres to a fixed exchange regime, then any foreign borrowing must be sterilized in foreign exchange market so as to maintain the exchange rate at the prescribed level. But this means that the central bank has to increase the monetary base by buying up the excess supply of foreign exchange in return for additional reserves that are injected into the system.

· Yet, when floating exchange rate regime dominates in the economy, external borrowing to finance budget deficit allows the government to avoid the increase in monetary base and money supply and thus prevent inflationary developments. Among consequences of such policy are the appreciation of exchange rate and negative pressures on tradable goods sector due to deterioration of its competitiveness in international markets.

Date: 2015-02-28; view: 632