11.2 Financing the psncr

11.2.2The sale of bonds to banks

So far we have been assuming that it makes no difference to whom government

securities are sold. This is clearly not so in two cases – the sale of bonds (and treasury

bills) to the banking sector, and the sale of bonds overseas. Consider rstly the sale

of bonds to the banking sector and the ways in which this differs from bond sales to

the private sector (M4PS).

Let us assume that there is an increase in government expenditure to pay for

increased wages of nurses in the NHS. With no change in taxation revenue, the

PSNCR increases. The wage increases are deposited in bank accounts. Bank deposits

(bank liabilities) increase. Suppose, however, that the Debt Management Ofce

nances the increased PSNCR by selling bonds to the M4PS, which is willing to

purchase additional bonds at the current yield. The M4PS substitutes government

bonds for bank deposits (assumed to be non-interest-bearing) and the system returns

to equilibrium when bank deposits have fallen by the full amount of the increase

in PSNCR. However, this fall is just matched by the increase in deposits resulting

from the increase in government expenditure. The net result of the operation – the

increased government expenditure nanced by the sale of bonds to the M4PS – is an

unchanged level of bank deposits, and hence of the money stock.

Consider next what happens if the M4PS is unwilling to purchase more govern-

ment securities at existing bond yields. Then, the increase in government expenditure

will, in effect, be nanced by the banking system. Assume the nurses are paid by

government cheques. Their now larger cheques are deposited with banks, increasing

bank liabilities. But this is matched by increases in the deposits of the monetary

sector with the Bank of England. Now, there is no equivalent running down of

bank deposits since interest rates do not rise. Banks next realise that their deposits

at the Bank of England are higher than they need and run them down by increasing

their holdings of all other assets (including government securities). As they increase

their loans to the personal and corporate sectors, bank deposits and bank assets rise

further. Deposits (and hence the size of the balance sheet of the banking sector) con-

tinue to rise, following the familiar money multiplier process, until banks’ holdings

of government securities have increased by the size of the increase in PSNCR.

Residual (monetary) nancing of public sector decits:The nancing of the PSNCR

by the sale of government bonds to the banking sector, causing an increase in the

money supply.

The net result is an increase in the money supply. This process is known as the

residual nancing or the monetary nancing of the PSNCR. The government is

borrowing from the banking sector, and the effect on the money supply is the same

as when the M4PS increases its borrowing from banks. This gives rise to the money

supply identity

Money supply PSNCR M4PS lending to the public sector

D bank lending to M4PS

overseas impact on money supply

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Chapter 11 • Government borrowing and nancial markets