11.4The public debt and open market operations

The existence of the public debt introduces the possibility of open market operations

– the sale or purchase by the government of securities for monetary purposes.

Suppose rst the government wishes to tighten monetary conditions and push up

interest rates but that at current rates it can sell to the M4PS all the securities it needs

to nance the PSNCR and to renance maturing securities. It chooses, however, to

offer its new securities at a higher interest rate. Members of the M4PS respond by

buying more securities than are needed, paying the government by cheque. This causes

both bank deposits (bank liabilities) and the banking sector’s deposits with the Bank

of England (bank assets) to fall. The banking sector will need to replenish its deposits

with the central bank and to do so will need to call in loans and sell off other assets,

including part of its holdings of government securities. As loans are called in, bank

deposits fall further and the process continues. The fall in bank deposits reduces the

size (or, at least, the rate of growth) of the money stock; the sale of previously issued

government securities by the banking sector forces their prices down and interest rates

up in line with the new issues. In turn, interest rates on other assets increase and the

interest rate rise sought by the government spreads throughout the economy. At

the end of the process, a higher proportion of the public debt will be nanced by the

M4PS; a lower proportion will be met by residual or monetary nancing.

The reverse open market operations case can be outlined easily. Here, the central

bank wishes interest rates to fall. It thus reduces the interest rate payable on new

securities. The M4PS will be unwilling to purchase at this low rate sufcient new

securities to fund the new PSNCR and to renance maturing issues. Government

expenditure thus leads to an increase in bank deposits and in banking sector deposits

with the Bank of England. The outcome is the same as in the monetary nancing

of the PSNCR which we considered in section 11.2.2. Banks acquire more govern-

ment securities, pushing down interest rates on them and leading to a generalisation

throughout the economy of the interest rate cut. This case is often referred to as a

‘purchase’ of its own securities by the central bank. We see here that instead of directly

purchasing its own securities, the authorities may simply determine the interest rate

payable on new issues so as to cause fewer such securities to be purchased by the

M4PS, leaving a higher proportion of the PSNCR to be nanced residually.

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		11.6 Summary
11.5	Debt management and interest rate structure

However, the existence of the public debt presents another problem for the author-

ities. Past issues of government securities (with the exception of a small number of

issues of undated stocks) sooner or later mature and must be redeemed. They must

then be replaced by new securities in order to renance the existing public debt.

In any nancial year, then, the authorities must sell securities equal to the current

PSNCR plus the value of old issues of securities maturing in that year. Two things

follow. Firstly, other things being equal, the government prefers to sell longer-dated

than shorter-dated stocks to reduce the rate at which the existing debt has to be

renanced. Secondly, the authorities need to construct a time prole of the debt that

avoids the possibility of too high a proportion of the existing debt maturing at the

same time. This is indicated by the long average maturity of the gilt portfolio. At the

end of March 2006, this was 13.09 years for all stocks (12.77 years for conventional

stocks; 13.95 years for index-linked stocks).

It remains, however, that within this constraint the authorities may choose the

prole of government debt. By so doing, they may hope (assuming that there is some

degree of segmentation in the market) to inuence the relationship between short

and long interest rates in the economy.

They may wish to do this to assist them in selling government securities. Gilts are

usually issued as longer-term securities and their attractiveness is inuenced by the

relationship between long and short rates. We have already seen that this played an

important part in the Duke of York strategy. Alternatively, as we saw in Chapter 7,

the government may wish to ‘twist’ the interest rate structure – usually, keeping long

rates low and pushing short rates up – in pursuit of macroeconomic objectives.