The initial expansionary impact of deficit spending on aggregate demand is lower when the government matches the deficit with debt-issuance compared to a situation when it issues no debt.
Answer: False
The answer is False.
The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).
The chapters always allege (as noted above) that governments have to 'finance' all spending either through taxation; debt-issuance; and/or money creation.
However, government spending is performed in the same way irrespective of the accompanying monetary operations. So the discussion in the mainstream textbooks is always misleading.
But for the purposes of this question, what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a fiscal deficit without issuing debt?
Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank.
The commercial bank in question would be where the target of the spending had an account
So the commercial bank's assets rise and its liabilities also increase because a deposit would be made.
The transactions are clear
1. The commercial bank's assets rise and its liabilities also increase because a new deposit has been made.
2. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).
Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.
This means that there are likely to be excess reserves in the 'cash system' which then raises issues for the central bank about its liquidity management.
The aim of the central bank is to maintain its target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.
When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.
Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.
So in this paradigm, central banks have to hold debt and conduct open market operations to manage its interest rate.
They can also achieve the same aim by just offering a return on the excess returns.
There is no sense that these debt sales have anything to do with 'financing' government net spending.
What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.
The only difference between the Treasury "borrowing from the central bank" and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target.
If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).
There is no difference to the impact of the fiscal deficits on net worth in the non-government sector.
Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.
However, the reality is that:
So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.
Finally, when the interest payments on the debt start to flow, then the net worth of the non-government sector increase further.
Which is why the question asks about the 'initial' expansionary impact.
You may wish to read the following blog posts for more information:
That is enough for today!
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