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

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  • 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.

Suggested Citation

  • Stacey L. Schreft & Bruce D. Smith, 2001. "The conduct of monetary policy with a shrinking stock of government debt," Research Working Paper RWP 01-09, Federal Reserve Bank of Kansas City.
  • Handle: RePEc:fip:fedkrw:rwp01-09
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    References listed on IDEAS

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    1. Bruce D. Smith, 1991. "Interest on Reserves and Sunspot Equilibria: Friedman's Proposal Reconsidered," Review of Economic Studies, Oxford University Press, vol. 58(1), pages 93-105.
    2. 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.
    3. Schreft, Stacey L. & Smith, Bruce D., 2000. "The evolution of cash transactions: Some implications for monetary policy," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 97-120, August.
    4. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
    5. Greenwood, Jeremy & Smith, Bruce D., 1997. "Financial markets in development, and the development of financial markets," Journal of Economic Dynamics and Control, Elsevier, vol. 21(1), pages 145-181, January.
    6. Bruce Smith & J. Bhattacharya & Mark Guzman, 1998. "Some Even More Unpleasant Monetarist Arithmetic," Canadian Journal of Economics, Canadian Economics Association, vol. 31(3), pages 596-623, August.
    7. Smith, Bruce D, 1994. "Efficiency and Determinacy of Equilibrium under Inflation Targeting," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 4(3), pages 327-344.
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    Citations

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    Cited by:

    1. Eisei Ohtaki, "undated". "Asymmetric Liquidity Shocks and Optimality of the Freidman Rule," Working Papers e58, Tokyo Center for Economic Research.
    2. Edda Claus & Mardi Dungey & Renée Fry, 2008. "Monetary Policy in Illiquid Markets: Options for a Small Open Economy," Open Economies Review, Springer, vol. 19(3), pages 305-336, July.
    3. Samuel Huber & Jaehong Kim, 2017. "An overlapping generations model for monetary policy analysis," ECON - Working Papers 272, Department of Economics - University of Zurich.
    4. 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, May.
    5. Antinolfi, Gaetano & Keister, Todd, 2006. "Discount Window Policy, Banking Crises, And Indeterminacy Of Equilibrium," Macroeconomic Dynamics, Cambridge University Press, vol. 10(01), pages 1-19, February.
    6. Machicado, Carlos Gustavo, 2008. "Liquidity shocks and the dollarization of a banking system," Journal of Macroeconomics, Elsevier, vol. 30(1), pages 369-381, March.
    7. Rangan Gupta, 2005. "Costly State Monitoring and Reserve Requirements," Annals of Economics and Finance, Society for AEF, vol. 6(2), pages 263-288, November.
    8. Jung, Kuk Mo, 2016. "Uncertainty-Induced Dynamic Inefficiency and the Optimal Inflation Rate," MPRA Paper 69715, University Library of Munich, Germany.
    9. 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.
    10. 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.
    11. Stacey Schreft & Bruce Smith, 2008. "The social value of risk-free government debt," Annals of Finance, Springer, vol. 4(2), pages 131-155, March.
    12. Joe Haslag & Antoine Martin, 2003. "Optimality of the Friedman Rule in Overlapping Generations Model with Spatial Separation," Working Papers 0306, Department of Economics, University of Missouri.
    13. Eisei Ohtaki, "undated". "Optimality of the Friedman rule under ambiguity," Working Papers e103, Tokyo Center for Economic Research.
    14. Joseph Haslag & Chao Gu, 2012. "Unconventional Optimal Repurchase Agreements," 2012 Meeting Papers 431, Society for Economic Dynamics.
    15. Chao Gu & Joseph Haslag, 2014. "Unconventional Optimal Open Market Purchases," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 17(3), pages 543-558, July.
    16. repec:cuf:journl:y:2013:v:14:i:3:paal is not listed on IDEAS
    17. Chao Gu & Joseph Haslag, 2011. "Endogenous Credit Cycles," Working Papers 1114, Department of Economics, University of Missouri.

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    Keywords

    Monetary policy ; Fiscal policy;

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