MMP Blog #18: Fiscal and Monetary Policy Operations in a Nation that Issues its Own Currency

By L. Randall Wray

This week we will begin to examine our next topic: government spending, taxing, interest rate setting, and bond issue. We will examine fiscal and monetary policy formation by a government that issues its own currency. We will bear in mind that the exchange rate regime chosen does have implications for the operation of domestic policy. We will distinguish between operational procedures and constraints that apply to all currency-issuing governments and those that apply only to governments that allow their currency to float. Over the previous 17 (!) weeks we have touched on much of this, but now it is time to get down to “brass tacks” to look at some of the nitty-gritty. As always, we are trying to stay true to the purposes of a “Primer”—a fairly general analysis that can be applied to all nations that issue their own currency. We will note where the results only apply to specific exchange rate regimes. And we will get into some of the procedures adopted that effectively “tie shoelaces together”—self-imposed constraints. This week we will provide a quick overview of general principles.

Statements that do not apply to a currency-issuer. Let us begin with some common beliefs that actually are false—that is to say, the following statements do NOT apply to a currency-issuing government.

  1. Governments have a budget constraint (like households and firms) and have to raise funds through taxing or borrowing 
  2. Budget deficits are evil, a burden on the economy except under some circumstances
  3. Government deficits drive interest rates up, crowd out the private sector…and necessarily lead to inflation
  4. Government deficits leave debt for future generations: government needs to cut spending or tax more today to diminish this burden 
  5. Government deficits take away savings that could be used for investment 
  6. We need savings to finance investment and the government’s deficit 
  7. Higher government deficits today imply higher taxes tomorrow, to pay interest and principle on the debt that results from deficits

While these statements are consistent with the conventional wisdom, and while they are more-or-less accurate if applied to the case of a government that does not issue its own currency, they do not apply to a currency issuer.

Principles that apply to a currency issuer. Let us replace these false statements with propositions that are true of any currency issuing government, even one that operates with a fixed exchange rate regime

  • The government names a unit of account and issues a currency denominated in that unit;
  • the government ensures a demand for its currency by imposing a tax liability that can be fulfilled by payment of its currency;
  • government spends by crediting bank reserves and taxes by debiting bank reserves; 
  • in this manner, banks act as intermediaries between government and the nongovernment sector, crediting depositor’s accounts as government spends and debiting them when taxes are paid; 
  • government deficits mean net credits to banking system reserves and also to nongovernment deposits at banks;
  • the central bank sets the overnight interest rate target; it adds/drains reserves as needed to hit its target rate; 
  • the overnight interest rate target is “exogenous”, set by the central bank; the quantity of reserves is “endogenous” determined by the needs and desires of private banks; and the “deposit multiplier” is simply an ex post ratio of reserves to deposits—it is best to think of deposits as expanding endogenously as they “leverage” reserves, but with no predetermined leverage ratio; 
  • the treasury cooperates with the central bank, providing new bond issues to drain excess reserves, or retiring bonds when banks are short of reserves; 
  • for this reason, bond sales are not a borrowing operation used by the sovereign government, instead they are a “reserve maintenance” tool that helps the central bank to hit interest rate targets; 
  • the treasury can always “afford” anything for sale in its own currency, although government always imposes constraints on its spending; and 
  • lending by the central bank is not constrained except through constraints imposed by government (including operational constraints adopted by the central bank itself). 

Some of these statements will seem cryptic at this point. We will clarify further in the following weeks. Here we are setting out the general principles that will be discussed later in order to contrast them with the “conventional wisdom” that likens a government’s budget to a household budget.

Let us be careful to acknowledge that these principles do not imply that government ought to spend without constraint. Nor does the statement that government can “afford” anything for sale in its own currency imply that government should buy everything for sale in its currency. Obviously, if things are for sale only in a foreign currency, then government cannot buy them directly using its own currency.

These principles also do not deny that too much spending by government would be inflationary. Further, there can be exchange rate implications: if government spends too much, or if it sets its interest rate target too low, this might set off pressure to depreciate the currency. This means that the government’s interest-setting policy as well as its budget policy will be mindful of possible impacts on exchange rates and/or inflation rates; in that sense, interest-setting and fiscal policy are “constrained” by government’s desire to control the exchange rate or the inflation rate.

This brings us to the exchange rate regime: while the principles above do apply to governments that peg their exchange rates, they must operate fiscal and monetary policy with a view to maintaining the peg. For this reason, while these governments can “afford” to spend more, they might be choose to spend less to protect their exchange rates. And while government can “exogenously” lower its interest rate target, this might conflict with its exchange rate target. For that reason, it might choose to keep its interest rate target high if it is pegging its exchange rate.

Next week we will begin to examine in more detail the government’s budget when it is the issuer of the currency.

22 Responses to MMP Blog #18: Fiscal and Monetary Policy Operations in a Nation that Issues its Own Currency

  1. "the treasury cooperates with the central bank, providing new bond issues to drain excess reserves, or retiring bonds when banks are short of reserves; "You haven't mentioned 'Interest on Reserves' in the principles.Is it the case that if there is 'Interest on Reserves' (IOR) the whole bond issuing routine (both short and long bonds) can be dispensed with completely?There are subtle differences between bonds and IoR. Is one better than the other from an MMT perspective.My understanding was that most of the world's major central banks have moved to Interest on Reserves as the maintenance tool of choice – rather than messing around with short term Bills. Is that the case?

  2. "Government deficits take away savings that could be used for investment ""We need savings to finance investment and the government’s deficit "With my Devil's Advocate cap on now.Although arguably these are untrue in nominal terms, is there a case to answer on the above two points in Real terms?One of the central accusations against MMT is that it suffers from 'Nominalism' and can't say anything useful about interactions in the Real economy.

  3. How Does Central Bank influence the interest rate? Just buying or selling bonds?BestDario

  4. Suggestion:As "exo" and "endo" are in the eye of the genus, it would help to know in advance whose perspective is envisioned. Regarding:[T]he overnight interest rate target is “exogenous”, set by the central bank; the quantity of reserves is “endogenous” determined by the needs and desires of private banks; and the “deposit multiplier” is simply an ex post ratio of reserves to deposits—it is best to think of deposits as expanding endogenously as they “leverage” reserves, but with no predetermined leverage ratio." It is not transparently clear who is "exo" and who is "endo". It is fairly readily determinable that the subjective perspective is that of the private banks, but only to people who have been following the discussion for a while. I think a primer should be more explicit. The last statement about "leveraging reserves" is pretty mysterious even to me.Still, I am lovin' it.Cheers

  5. When I see a Bloomberg, etc, quote on the 10 yr government treasury note is that quote based entirely on the secondary market rather than an intitial government auction rate? In other words, how much does the secondary bond market influence price an yield?

  6. > We need savings to finance investment and the government’s deficit why is this false? The deficit gets bigger and bigger, how else can it be resolved? if it doesn't have to be paid off somehow, why doesn't the government simply repudiate the debt?

  7. I'm excited that you are heading towards the details!One thing in this post that seems wrong to me. You write:"Let us replace these false statements with propositions that are true of any currency issuing government, even one that operates with a fixed exchange rate regime"Later, you write:"For this reason, while these governments can “afford” to spend more, they might be choose to spend less to protect their exchange rates. And while government can “exogenously” lower its interest rate target, this might conflict with its exchange rate target. For that reason, it might choose to keep its interest rate target high if it is pegging its exchange rate."I suppose this might just be semantics, but if you are taking a fixed exchange rate regime as given, the government is not really "choosing" to spend less in certain scenarios. Your language seems to suggest that the government can have it both ways, i.e. to have a fixed exchange rate regime and to also have the flexibility of your principles.

  8. There is a significant difference in whether the government puts the money it creates into circulation via interest payments to "lenders"– or through the sort of 'employer of last resort' program you recommend elsewhere. [There is a persistent superstition you're contending with here, that without the ritual of sacrificing to those lenders, the money "wouldn't be based on anything."]One method concentrates claims on real-world goods & labor in the hands of people who only use these claims to corrupt the government and hoard more claims– while the other would circulate nourishment through the body of the society.

  9. @Forrest: I'll defer to Dr. Wray, but I believe the answer you're looking for is that Gov't puts the money it creates into "circulation" the form of reserves. I quoted circulation because you or I can't own reserves, only banks can. You or I can influence the level of reserves by depositing or withdrawing (any bank accepted IOU or cash).

  10. Like others who have posted on this topic, I too am interested in the exogenous nature of the interest rate vis-a-vis what is described as "hitting the target". I'm reading the fed funds wiki (I know, not authoritative), but I'm assuming the target is referring to the fed funds rate, and not the discount rate. The discount rate is meant to be essentially a penalty of sorts, right? In that the Fed would prefer all business to be settled intrabank. So is the logic that excess reserves need to be drained or else the intrabank rate will slip below the target? Much obliged as always.

  11. Does the ratio of interest expense to GDP also not apply to a currency issuer? Specifically I'm trying to wrap my head around if interest expense on debt was greater then GDP.

  12. Also why does MMT not present the GDP income view as well as the GDP expenditure view in sectoral balances. That is,GDP = C+G+I+X-MGDP = C (70%) + G (20%) + I (12%) + X-M (-2%)And GDP income approachGDP = W + NOS + D + TW = wagesNOS = Net operating Surplus (profits)D = depreciationT= Taxes on Imports less SubsidiesGDP = W (55%) + NOS (25%) + D(13%) + T (7%)Some of my observation maybe that for Individuals: 55% wages generates 70% of consumption.Business: 25% profits + 13% depreciation (38%) generates 12% investmentGovernment: 20% deficits spending -2% of imports (18%) are "funded" by 7% of taxes on importsAlso the income approach may lead to me to a different conclusion on how to maintain GDP growth. That is instead of deficit spending, perhaps to increase tax on imports. Or instead of government spending have negative income taxes for wage earners or whatever group that needs to be targetted. Also are the proportions "healthy" for an economy – that is, why do corporations get 25% profits and depreciation and only invest back 12%. And are wages too low for the given level of consumption?Also they may choose to ensure deficit spending/tax cuts is not funneled to corporate profits but rather to wages or where ever they are needed.My comments may not be accurate, but my general question is why ignore the income approach for GDP

  13. @NeilClearly the view that MMT suffers from nominalism is unwarranted. Some of its central messages are that, one, both real side and monetary side are intertwined, two, to clearly understand an economic problem one must be able to determine if the problem lies in the monetary or the real side. The clearest example of that is probably social security. The current debates are all on the monetary side (how can we make sure that social security checks do not bounce?) when the actual problem is on the real side (can we provide the goods and services retirees need?). This leads to very different policies.

  14. The level of reserves is endogenous, determined by the needs of banks. Could the Central Bank compel (rather than induce, through payment of a support rate) banks to maintain higher reserve levels than those they would endogenously maintain in keeping with their needs? I inquire because it seems to me that such a policy could preserve CB control of short term rates without the issuance of debt to drain reserves. Perhaps that's not so, or perhaps it's unnecessary. But if it were possible, it might be a counter to the objections of those MMT critics who disagree with MMT because they prefer to preserve a high degree of CB flexibility to set short term rates. It appears to me that MMT proponents tend to favor very low short term rates and to rely on the public deficit alone as a tool to manage inflation.

  15. Could there at some point be a detailed explanation of how treasuries are issued, the role of primary dealers, what accounts are used, etc(more detailed than mosler's 'money gets switched from one account to another')? Does the amount of bond issuance always match the deficit exactly, any time lags? And so what would happen if there's no private investors wanting treasuries? I assume the primary dealers can purchase the auction due to their mandate to make a market and they'd have the reserves available from previous deficit spending. But since their reserves get soaked up into bonds, could there ever be problems with check clearing down the road? The whole bond issuance/borrowing/national debt seems to be a critical point I'd like to understand completely…Could govt stop issuing bonds and liquidate all treasuries? What would be the mechanics of spending without selling bonds, what are the self-imposed constraints preventing this?

  16. Dear Prof. WrayI really need to understand this. Let me explain.I'm going to a bank asking a loan and I get it.Does the bank create the money from nothing or the bank should ask the money to another entity?Thanks a lotDario

  17. Eric Tymoigne: Clearly the view that MMT suffers from nominalism is unwarranted. Well, one has to define "suffering from nominalism" first. If it means (a) getting the nominal story straight & (b) clearly distinguishing the nominal from the "real", thereby helping get the real story straight – well MMT emphatically does suffer from nominalism, a disease which everyone should spread. IMHO, much more than the art of confusing stocks & flows, "economics" has been the art of confusing the real & the nominal.

  18. Hi Dario, Let me try this (I will tremulously post under my true name for the sake of the mortification of the flesh that I will experience if I get it wrong). 1) Suppose you want to borrow X$ from a bank and you want the money you have borrowed to be deposited into a checking account at the same bank. That's easy: the bank drafts a note that you sign, promising to pay and pledging some security if you fail. You have just given the bank an asset worth X$ + interest. The bank is instantaneously X+$ richer. That's not fair.To remedy this injustice, the bank also creates a checking account in your name and inserts the number X$ into the account balance of that account on the banks computer system. The bank just created X$ and gave them to you.Accounting is a miraculous art. Money ex nihilo. Banks are granted the power to create horizontal money out of nothing, though they are supposed to do so only in response to the receipt of trustworthy promises to pay the money back. No net financial asset value has been created, however (well, the note presumably has a present value slightly greater than X$, so perhaps there is a slight increase in net financial asset value in this transaction) sincethe bank has a liability of X$ (the X$ deposit that it holds but that belongs to you) and an asset (your secured promise to pay) that is worth X$ (or a little more, given the present value of the future income stream and net of the credit risk. But we trust that the loan was expertly underwritten :P ) This sounds like an outrageous procedure. How can a credit system possibly be run like that? Well, there are regulators to keep unscrupulous people from signing fraudulent promises to pay and absconding with the ex nihilo $ created by the bank (and kicking a little back to the bank principals along the way,perhaps.) The regulators sometimes go to sleep on their or are sedated by crooked politicians and so one has things like the S&L crisis and its more illustrious successors of our time.I think that's correct.Now for my well-deserved mortification of the flesh.2) What if, instead, you don't want a checking account at the bank that made the loan; you want a check that you can take deposit in some other bank.The bank still writes the note as before. It is now $X+ richer and there is again an injustice. The bank must give you X$ in the form of that check that you will take somewhere else to deposit. The bank does something that looks even to me a teeny bit disreputable. It adds the number X$ to its own in house checking account (money that it owns that is deposited in an account at itself) and then writes you a check drawn against that checking account. You take the check and deposit in in an account belonging to you at another back. THe check clears through the payments system and that teeny-weeny bit disreputable X$ that the bank had given itself vanished from its in house checking account and appears in your checking account at the other bank. I believe that that's how it's done. Money ex nihilo, but matched with expertly underwritten and well secured promises to pay, except when it isn't. I welcome an alternative explanation.2)

  19. "government spends by crediting bank reserves and taxes by debiting bank reserves"Does this influence the capacity of the bank to lend money?BestDario

  20. Hi Dario, I'll try again, and perhaps humiliate myself. As I understand it, banks need reserves on deposit with the Fed to lubricate their payments. The amount of reserves needed to lubricate payments is connected to Prof Wray's point that the reserves level is determined endogenously by bank needs.Banks aren't allowed to have negative reserves balances, or not allowed to have them for prolonged periods of time (I think that that might allow them to do fraudulent things like credit their in-house accounts and then write checks to the bank officers to fund immediate retirement to Switzerland). If they go negative, they have to borrow reserves from somewhere, either another bank or from the Fed itself, which creates them out of nothing (I think). The constraint on bank lending to you and me is not their reserves level (they can always get more reserves by borrowing from other banks or, at a pinch, from the Fed), but their capital adequacy ratios, which are supposed to be monitored by the regulators, who hopefully have not dozed off or been sedated. I am no more than superficially acquainted with the details of bank capital, but the point is that the bank balance sheet has a list of liabilities (what the bank owes to other people, including retail and commercial deposits, and other ways that the bank may have borrowed horizontal money) and a list of assets, which includes investments the bank has made (including the note you signed when you borrowed your X$). If the bank has been well managed, the value of its assets will exceed the value of its liabilities. The excess is (more or less; I'm not familiar with the accounting details) the equity that the owners of the bank have. The different kinds of assets on the bank balance sheet have different properties and different degrees of risk (likelihood of default, price sensitivity to changes in the external world, etc). It is a bad thing for a bank to have a lot of assets that have high likelihood of declining in price if external conditions change (imagine a bank that has a lot of subprime mortgage backed securities on its balance sheet. Or don't imagine; cast your gaze in the direction of the larger US banks).Such a bank might find itself in the future in a situation in which the value of its liabilities exceed the value of its assets. Why is that bad? I think that the principal reason that it's bad is that if you don't try to prevent this, there is a huge opportunity for fraudulent dealing (such as happened in the S&L crisis) and the potential for a limitless expansion of the horizontal money supply, which would be inflationary. Wiser heads than mind should correct me expand on this. So the limit on bank lending (which you are right be concerned with, I think) has to do with the safety of its balance sheet. And this does impose a limit on how much banks can lend. After you have lent to all the creditworthy and safe borrowers to their uttermost capacity to safely borrow, the only way to lend more is to take excessive risk onto the asset side of your balance sheet by lending to people who will default at a higher rate than the return on your loans. I believe that this is precisely what happened in the subprime MBS boom. I hope that's helpful. MMT may look superficially like it cannot be true. But it is.

  21. Hi Dario, A point that I think is really worth remembering is that the horizontal money that banks create ex nihilo and lend into the economy is supposed to be matched with expertly underwritten secured notes. The outer limit on the banking system's capacity to create horizontal money might be considered to be the total amount of price-stable collateral that could be pledged as security in those notes. It's these secured notes that are on the bank's balance sheet (along with other investments it has made). So a financial system consisting of properly managed banks has a strong constraint on the total amount of horizontal money it can create out of nothing. But the key is "properly managed", and that's why the integrity of bank officers and the alertness of the regulators (and the transparency and oversight of alternative systems of credit creation — the "shadow banking system") are so important and why you will see many posts by William Black at this weblog. Read every one of those; you will gain a great deal of understanding of what has gone wrong in our time.

  22. This question had basically been asked, but I'll state it another way. Is the quantity of reserves effectively exogenous in a system where reserves are remunerated at the policy rate (a floor system) and the quantity of reserves is far in excess of the amount demanded by the banking system for settlement/liquidity purposes (and reserve requirements)? In other words the current circumstances in the US? I know the primer is meant to be general but I think addressing this would be useful illustrative. Thanks for putting the primer together.