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The conduct of monetary policy with a shrinking stock of government debt

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Author Info

  • Stacey L. Schreft
  • Bruce D. Smith

Abstract

In many countries, government-budget surpluses have led to a decline in the amount of federal government debt outstanding. This paper considers the consequences of this development for a central bank that conducts monetary policy through open market operations in treasury debt. A model is presented in which a treasury taxes, spends, and issues debt; a central bank conducts monetary policy through open market operations; and banks are intermediaries for all private savings. The model suggests potentially severe consequences from a shrinking stock of government debt in the absence of a change in the conduct of monetary policy. Specifically, the nominal interest rate and the inflation rate cannot be below their seigniorage-maximizing levels. In effect, a small stock of debt combined with restrictions on a central bank’s portfolio can put the economy on the Pareto inferior side of the seigniorage Laffer curve, with an unnecessarily high inflation rate and nominal interest rate. Moreover, if the government also runs a primary budget deficit, equilibrium can fail to exist. The model presented can yield estimates of how much debt must be outstanding to avoid each situation. Discount-window lending is a feasible—and desirable— alternative method for conducting monetary policy. It relaxes any restrictions on the attainable set of interest rates and inflation rates implied by a decline in the stock of government debt outstanding. Unless the economy is on the Pareto inferior side of the Laffer curve, welfare is higher when discount-window loans are made at market-determined interest rates.

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Bibliographic Info

Article provided by Federal Reserve Bank of Cleveland in its journal Proceedings.

Volume (Year): (2002)
Issue (Month): ()
Pages: 848-886

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Handle: RePEc:fip:fedcpr:y:2002:p:848-886

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Keywords: Monetary policy ; Debts; Public;

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References

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  1. Smith, Bruce D, 1994. "Efficiency and Determinacy of Equilibrium under Inflation Targeting," Economic Theory, Springer, vol. 4(3), pages 327-44.
  2. Bhattacharya, Joydeep & Guzman, Mark G. & Smith, Bruce D., 1998. "Some Even More Unpleasant Monetarist Arithmetic," Staff General Research Papers 5084, Iowa State University, Department of Economics.
  3. Greenwood, J. & Smith, B.D., 1995. "Financial Markets in Development, and the Development of Financial Markets," RCER Working Papers 406, University of Rochester - Center for Economic Research (RCER).
  4. Stacey L. Schreft & Bruce D. Smith, 1999. "The evolution of cash transactions : some implications for monetary policy," Research Working Paper 99-02, Federal Reserve Bank of Kansas City.
  5. Smith, B.D., 1988. "Interest On Reserves And Sunspot Equilibria: Friedman'S Proposal Reconsidered," RCER Working Papers 119, University of Rochester - Center for Economic Research (RCER).
  6. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  7. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
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Citations

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Cited by:
  1. Carlos Gustavo Machicado, 2006. "Liquidity Shocks and the Dollarization of a Banking System," Development Research Working Paper Series 09/2006, Institute for Advanced Development Studies.
  2. Joseph H. Haslag & Antoine Martin, 2007. "Optimality of the Friedman Rule in an Overlapping Generations Model with Spatial Separation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(7), pages 1741-1758, October.
  3. Joseph H. Haslag & Antoine Martin, 2003. "Optimality of the Friedman rule in overlapping generations model with spatial separation," Research Working Paper RWP 03-03, Federal Reserve Bank of Kansas City.
  4. Bruce D. Smith & Beatrix Paal & Ke Wang, 2005. "Monopoly versus Competition in Banking: Some Implications for Growth and Welfare," 2005 Meeting Papers 435, Society for Economic Dynamics.
  5. Stacey Schreft & Bruce Smith, 2008. "The social value of risk-free government debt," Annals of Finance, Springer, vol. 4(2), pages 131-155, March.
  6. Joseph Haslag & Chao Gu, 2012. "Unconventional Optimal Repurchase Agreements," 2012 Meeting Papers 431, Society for Economic Dynamics.
  7. Joydeep Bhattacharya & Joseph H. Haslag & Antoine Martin, 2005. "Heterogeneity, Redistribution, And The Friedman Rule," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(2), pages 437-454, 05.
  8. Chao Gu & Joseph Haslag, 2011. "Endogenous Credit Cycles," Working Papers 1114, Department of Economics, University of Missouri.
  9. Edda Claus & Mardi Dungey & Renee Fry, 2006. "Monetary Policy In Illiquid Markets: Options For A Small Open Economy," CAMA Working Papers 2006-17, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  10. Beatrix Paal & Bruce Smith & Ke Wang, 2013. "Monopoly versus Competition in Banking: Some Implications for Growth and Welfare," Annals of Economics and Finance, Society for AEF, vol. 14(3), pages 871-910, December.
  11. Chao Gu & Joseph Haslag, . "Unconventional Optimal Open Market Purchases," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
  12. Gaetano Antinolfi & Todd Keister, 2003. "Discount Window Policy, Banking Crises, and Indeterminacy of Equilibrium," Working Papers 0305, Centro de Investigacion Economica, ITAM.
  13. Rangan Gupta, 2004. "Costly State Monitoring and Reserve Requirements," Working papers 2004-33, University of Connecticut, Department of Economics, revised Jul 2005.
  14. Carlos Gustavo Machicado, 2007. "Growth and Banking Structure in a Partially Dollarized Economy," Development Research Working Paper Series 02/2007, Institute for Advanced Development Studies.

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