Deficits and the demand for money.

• Author: Tanner, Evan

1. Introduction

   In recent years, the large budget deficits of the Federal Government have renewed interest in the effects of government debt on private sector behavior. To date, empirical research has focused on the relationship between debt and two key variables, consumption and interest rates.(1) By contrast, empirical research on the effects of government debt on other variables of interest to macroeconomists is limited. This paper examines the relationship between government debt and one such variable, real money balances. The neglect of government debt as a determinant of money demand is surprising. Many traditional macroeconomic models, such as Blinder and Solow's |9~ influential work, include government debt as an argument to the money demand function. Moreover, macroeconomic theorists have long been aware that a government debt -- money demand relationship has important implications for the efficacy of fiscal policy.(2)

   This paper examines the relationship between government debt and real money holdings over the 1950-1990 period. A positive money -- debt relationship was previously noted by Butkiewicz |12~ and Deravi, Hegji, and Moberly |15~ (hereafter referred to as DHM). Our work improves upon this research in two ways. First, in contrast to Butkiewicz |12~ and DHM |15~, we investigate the time-series properties (stationarity, cointegration) of relevant variables. Second, we distinguish between supply-side and demand-side explanations of the debt-money relationship. The explanation advanced by Butkiewicz |12~ and DHM |15~ is that an increase government debt is perceived by the private sector as an increase in net wealth and hence should increase money demand.(3) This explanation ignores a potentially important connection between government debt and money supply. If the Federal Reserve monetizes debt, and if the private sector's adjustment to this monetization is lagged, then debt and real money balances will exhibit a positive correlation in the short run (but not the long run) even in the absence of a net wealth effect in money demand. It is thus crucial to distinguish between money demand and supply effects in empirical work on debt and real money holdings. To distinguish between these effects we develop a two-equation model of money demand and supply. Our model draws on Carr and Darby's |13~ "shock-absorber" framework, as well as work by Mishkin |39; 40~ and Bohara |10~.

   The empirical results reported in this paper are stronger than those reported by Butkiewicz |12~ or DHM |15~. Their research found a contemporaneous relationship between money demand and government debt over the 1950-1973 period. We confirm this finding. We also find a strong evidence of lagged demand-side effects of changes in real government debt on real money holdings over the entire 1950-1990 period as well as the 1973-1990 period. However, we find no evidence that deficits are monetized. Thus, the positive correlation between money demand and government debt appears to be purely a result of demand-side factors.

   The paper is organized as follows. In section II, we discuss the role of government debt in money demand and supply functions. In section III, we present the empirical analysis. We first test for the stationarity of the relevant variables. The evidence suggests that these variables are level non-stationary but difference stationary. Therefore, we perform co-integration tests on the money demand and monetary base reaction functions. For both functions, the null hypothesis of no-cointegration is not rejected. Finally, we bring demand and supply elements together using a "shock-absorber" money demand model. We jointly estimate money demand and monetary base reaction functions using the technique suggested by Mishkin |39; 40~. We find strong evidence that deficits increase the demand for money. By contrast, we find little evidence for a supply-side relationship. Section IV presents our concluding comments.

2. Deficits and the Demand for and Supply of Money

   In this section, we discuss the role of government debt in money demand and supply. We begin with money demand. Economic theory suggests that money demand is related to a scale variable (i.e., transactions or wealth) and an opportunity cost measure. In equation (1), |m.sup.d~ is real money demand, y is real income, R is the nominal interest rate.

   |m.sup.d~ = f(y, R, b) (1)

   The inclusion of real government debt (b) in a money demand equation such as (1) can be justified on several grounds. The simplest justification is a net wealth effect, as discussed by authors such as Blinder and Solow |9~, Butkiewicz |12~, Mankiw and Summers |35~ and DHM |15~. Of course, if government bonds are part of net wealth, Ricardian Equivalence does not hold. However, there are models which imply a relationship between real money balances and government debt that do not rely upon a net wealth effect. One such model was suggested by Rodriguez |45~. He demonstrates that, in a cash-in-advance model, issuance of government debt increases transactions and hence money demand. Moreover, recent work on the liquidity effect by Grossman and Weiss |26~, Rotemberg |46~, Lucas |33~ and Christiano |14~ also derive conditions under which an open market operation increases real money holdings.(4)

   There is also a supply-side explanation for a money-debt relationship that is not considered in previous work. Increases in government debt may be monetized by the government. If the private sector's adjustment to money supply shocks is not instantaneous, then positive money supply surprises lead to short run increases in real money holdings. This mechanism requires both that real money balances act to absorb real money shocks, as in the model of Carr and Darby |13~, and that deficits are monetized. Many papers, including Niskanen |41~, Hamburger and Zwick |27~, Allen and Smith |2~, Allen and McCrickard |1~, and Joines |29~, have investigated whether deficits are followed by increases in the money supply. To date, however, the empirical results on this question are mixed and the issue remains unsettled.

   The theoretical foundations for a money supply reaction function are not well-developed. Our choice of explanatory variables for this function is therefore determined by earlier studies. Previous research found that the Federal Reserve has targeted interest...