Obligatory relationship between the Deficit and Interest Rates

Obligatory relationship between the Deficit and Interest Rates

The nation’s money supply is closely linked to deficit spending by the Government. The money grows rapidly when the deficit in the government budget is large and grows slowly when the deficit is small or when surpluses occur.

According to analysis of the statistical data from Bank of Albania (BoA) reports and bulletins regarding to the aggregate M1 and M2, the support of the core idea of this comment is due to efforts by the Bank of Albania to stabilize interest rates. This leads the system to respond to deficits by buying Government securities and/or taking other actions that result in increases in the money supply.

In analyzing the relationship between Government budget deficits and surpluses and the money supply, it is useful to distinguish direct effects from indirect effects. Budget deficits occur when government expenditures exceed revenues.

A deficit will lead to a direct rise in the money supply if the BoA finances the deficit not by borrowing but by drawing down balances it holds at commercial banks. That is because government expenditures result in a shift of funds into money balances held by the public, and out of deposit balances held by the Ministry of Finance (MoF), which are not a part of the money supply.

The government revenues, though, result in a shift out of the public’s money balances and into MoF deposits. Therefore, when expenditures exceed revenues, money balances will increase and budget deposits will fall.’ Similarly, when revenues exceed expenditures and the MoF does not use the resulting surplus to repay debt held by the public, money balances will decline and MoF deposits will rise. In practice, changes in MoF deposits arising from deficits and surpluses may importantly affect the money supply over short periods, but are quantitatively unimportant for longer periods.

If deficits and surpluses are not accompanied by changes in MoF deposits, they will not directly alter money balances. When a deficit is accompanied by borrowing, the increase in money due to expenditures exceeding revenues is offset by a decline in the money balances of those who the obligations issued by the MoF.

Similarly, when a surplus is accompanied by debt repayment, the decline in money due to revenues exceeding expenditures is offset by an increase in the money balances of those who were holding redeemed securities.

Deficits and surpluses unaccompanied by changes in MoF deposits may indirectly affect money. These indirect effects may be both quantitatively significant and long-lived and may result in a correlation between deficits and surpluses and money.

However, the deficit and money may be related for reasons other than or in addition to the behavior of the BoA. The public and commercial banks, as well as the BoA system, may respond to deficit-induced alterations in interest rates in ways that affect money.

In the latter part of a recession and the early part of an economic recovery, for example, when unemployment is high and the inflation rate is low, the BoA may allow interest rates to decline or, at least, resist upward movements in rates. At the same time, due to the sluggishness of the economy, Budget revenues are declining and transfer-payment expenditures are rising so that the deficit is large. The consequent heavy MoF borrowing is placing upward pressure on interest rates. To prevent rates from rising, the BoA would purchase Government securities in volume and/or undertake other reserve-supplying actions, which would lead to large money supply increases.

Thus, large money supply increases would accompany the large deficit and would result, in part from the combination of the large deficit and the BoA ‘s policy of minimizing upward movements in interest rates.

As the economy moves into the middle stage of an economic expansion, when inflationary pressures develop and unemployment falls, the BoA may allow interest rates to rise. At the same time, due to the economic recovery, the deficit is small. The consequent reduction in MoF borrowing alleviates some of the upward pressure on interest rates. In allowing interest rates to rise, the BoA would be forced to moderate the increases in the money supply.

Thus, the small increases in money would accompany the small deficit and would be brought

about, in part, by the combination of the small deficit and the BoA’s policy of allowing interest rates to rise.

In the latter part of a recovery and the early part of a recession, when inflationary pressures are strong and unemployment is low, the BoA may be pushing interest rates up or, at least, resisting downward movements. At the same time, due to the inflation, the deficit is negative, i.e., a surplus occurs.

Consequently, the MoF is repaying debt, and this places strong downward pressure on interest rates. The BoA, in order to resist downward interest rate movements, would reduce the money supply.

Thus, the decline in the money supply would accompany the negative deficit and would be brought about, in part, by the combination of the negative deficit in the budget and the BoA ‘s policy of resisting downward movements in interest rates.

In summary, it is sometimes contended that the BoA may respond to deficit induced alterations in interest rates in a way that results in large money supply increases when the deficit is large, small money supply increases when the deficit is small, and declines in money when the deficit is negative.

While an examination of yearly data reveals little or no year-to-year association, regression analysis indicates that both M1 and M2 are related to and affected by the deficit. However, the analysis does not support the proposition that the BoA should respond to the deficit by taking actions that affect money. Rather, it appears that the BoA should allow the deficit to affect interest rates.

Instead of arising from BoA responses, the relationship between the deficit and money it might be due to responses on the part of the public and commercial banks. While M2 could be positively related to the deficit, MI should be negatively related.

That is, a deficit it is associated with an increase in M2 and a decline in M 1. It appears herefore that a deficit could led to a rise in interest rates, causing the public to shift out of MI balances into other assets.

As the offering rates on time deposits increase along with the increase in interest rates, part of the balances moving out of M1 will be transferred into the time deposit component of M2, offsetting part of the effect on M2 of the drop in M1. The decline in M1 and the rise in time deposits will increase the excess reserves of banks which, along with the increases in interest rates, should led banks to acquire assets.

Some of the prior decline in M1 it is thereby offset and the rise in time deposits will be augmented. On balance, these responses by the public and commercial banks to a deficit-induced rise in interest rates should result in a decline in M1 and an increase in M2.

The conclusion that the BoA should respond to the deficit by allowing it to result in interest rate changes is further supported by the results of regression analysis testing the relationship between the deficit and interest rates.

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