Worked example
Last updated
Last updated
When government spending is more than tax income what is the effect on the money supply
This is all assuming we have the laws in place that force governments to make up any shortfall by selling bonds.
Say that in one year the government tax take is $100Bn short of what they intend to spend.
Step 1. The government will print up $100Bn of bonds and offer them for sale.
Money supply: NO CHANGE
Immediately we run into a UK/US difference here… in the UK the gov. can sell bonds to non banks immediately whereas in the US they only sell to private banks - though those private banks may sell those bonds to non banks later, meaning that the banks just act as middlemen. I will assume the US model here because it ends up having the same effect as the UK so long as the banks go on to sell those bonds to non-banks..
Note: The government is unique in having an account at the Fed (the US Treasury General Account or TGA) despite not being a bank.
Step 2. Private banks buy up the $100Bn of bonds. For the sake of argument, say that it is Citibank that does the buying. Citibank will do this using central bank reserves which transfer from Citibank’s account at the Fed to the government's account (the TGA) at the Fed. This action in isolation has no effect on the money supply because reserves are not spendable by the public.
Money supply: NO CHANGE
The following steps 3 and 4 could happen in any order…
Step 3. The government is then free to spend $100B that they otherwise would not have had. Say the $100B was for new roads and was to be paid to “Roadbuilders Inc” who bank with Chase Manhattan Bank. The process of the government paying Roadbuilders is as follows. The Fed will instruct Chase to add $100B to Roadbuilders account and in compensation will transfer $100B of reserves from the TGA to Chase Manhattan's reserve account at the fed.
Money supply: increased by $100B
Step 4. The private banks that purchased the bonds are likely to sell them to non banks, like pension funds. Let’s say this is Citibank selling to Investo Pensions Inc. who happen to have an account at Citibank. In the process Investo will have its stock of demand deposits in their Citibank account reduced by $100B - no reserves move anywhere.
Money supply: reduced by $100B
Net effect of 1+2+3+4 = No change in money supply.