Government Spending Under Alternative Operational Arrangements in a Nutshell

Three previous posts (here, here and here) outlined the operational differences and similar macro effects of some alternative approaches to government spending; namely, bond issuance to the private sector, interest on reserves, and overt monetary financing. Since these posts were quite detailed, it might be worth spelling out the short answer to what is going on in each case. Further details can then be found in the earlier posts.

Bond sales to the private sector. This is the method that has been commonly adopted in most countries under “normal” circumstances, although in some countries central banks are currently paying interest on reserves.

From day to day, government expenditures occur. These entail crediting the reserve accounts of banks and the bank accounts of spending recipients. In aggregate, the effect of government spending is to add reserves. Meanwhile, taxes are getting paid. Taxpayers’ bank accounts are debited accordingly as are the reserve accounts of their banks. The aggregate effect of tax payments is to drain reserves.

On any given day, government spending is likely to differ from tax payments. If so, the central bank buys or sells already existing bonds to add or drain reserves as necessary to hit its targeted short-term interest rate.

If, over an extended period of time, government spending exceeds tax payments, the central bank needs to keep selling bonds to drain reserves. As a result, the central bank may go close to running out of bonds to sell. At this point, the fiscal authority (e.g. the Treasury) issues new bonds. This enables the central bank, indirectly, to obtain more bonds for the purpose of interest-rate management.

With the Treasury committed to issuing new bonds to the private sector, the central bank first needs to anticipate the effect of this on reserve balances. If the central bank did nothing in the event of a Treasury auction, there would be a depletion of reserves (as the private sector purchased bonds) and upward pressure on the short-term interest rate. The central bank prevents this by purchasing already existing bonds from primary dealers (in the first leg of a repurchase agreement). This adds reserves so that the Treasury’s new bonds can be purchased by the private sector without causing a reserve deficiency and interest-rate instability. By necessity, the central bank and Treasury communicate and coordinate their actions to ensure the process is conducted smoothly.

When the next round of government spending is scheduled to occur (which will add reserves), the central bank completes the second leg of the repurchase agreement by selling back bonds to primary dealers, neutralizing the effect of government spending on reserve balances. In this way, the level of reserve balances is managed to maintain interest-rate stability.

So, in a nutshell, the impact of ongoing government deficits is for the central bank to run out of the bonds it needs for interest-rate management. They are needed for monetary, not fiscal, policy. To address the situation, the Treasury then issues new bonds not to finance its spending but to enable the central bank to continue its method of draining reserves through bond sales as required to hit its policy rate.

Interest on reserves. In the case of interest on reserves, the central bank no longer needs to buy and sell bonds to hit its short-term interest rate. Instead, it simply pays its policy rate on reserves. This does not prevent the Treasury from issuing bonds for other reasons; for instance, to provide safe forms of saving to the private sector. But these bond issues no longer need to be tightly connected to the pattern of government spending and tax payments.

Overt monetary financing. One way to perform this operation is for the Treasury to issue bonds directly to the central bank. These bonds might or might not be interest-bearing. If they are, the central bank returns any profit to the Treasury. As always, government spending in excess of tax payments will add reserves. Under overt monetary financing, the central bank can simply allow the short-term interest rate to fall to zero.