11.2.3The sale of bonds overseas

This represents a cross between our two cases above. We assume that, in addition to

an increase in demand for bonds by the M4PS, bonds are sold abroad. To purchase

UK securities, foreigners must exchange foreign currencies for sterling. The foreign

exchange reserves of the Bank of England grow, but so too does the money supply.

In other words, to the extent that the foreign demand for government securities

increases, the system will return to equilibrium before bank deposits fall back to

their initial level. Or, to put it another way, the increase in government expenditure

causes bank deposits to rise; the sale of additional bonds to the M4PS causes bank

deposits to fall; but the inow of foreign currency counteracts the fall to some extent.

The net result is an increase in the money supply, but a smaller increase than if the

increase had been residually nanced.

Several other possibilities now arise. The increased international demand for sterling

may push up the value of the pound and this, in turn, may affect UK exports and

imports, as well as expectations about the future value of sterling. Again, once we

allow for the possibility that capital is internationally mobile, we need to recognise

that the demand for UK government securities will change whenever there is a change

in exchange rate expectations or whenever there is a change in foreign interest rates.

The relationship between the UK money supply and the size of the PSNCR becomes

even more complex and difcult to predict.

11.2.4Psncr, interest rates and the money supply – a conclusion

We have seen that the PSNCR may be nanced rstly by selling securities to the

M4PS. If all of the PSNCR is nanced in this way there will be no monetary con-

sequences. We have seen too that, although this may require an increase in interest

rates, this is by no means certain. The authorities may be able to sell more bonds

without raising interest rates through aggressive selling such as in the Duke of York

strategy or by widening the market for bonds. Again, their ability to sell more bonds

without interest rate increases will depend on the rate of growth of the economy and

on the way in which people respond to ination.

A second possibility is that the M4PS is willing to fund only part of the PSNCR at

existing interest rates and that the rest has to be met by residual or monetary nanc-

ing through the banking sector. To the extent that this is necessary, there will be an

increase in the size of the money stock. Whether this is inationary will depend on

whether the additional government expenditure which has to be nanced leads to

an increase in the output of the economy.

Thirdly, part of the PSNCR may be nanced through the sale of government secur-

ities overseas. This too will have monetary consequences through the consequent

increases in the UK’s holding of foreign exchange reserves. We have also seen that,

once we allow for the possibility of international capital movements, the attractive-

ness of UK securities will depend on exchange rate movements and expectations and

on changes in foreign interest rates – factors that are largely or entirely outside the

control of the domestic monetary authorities.

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