monetizing the debt - federal reserve bank of st. louis · 2019-10-17 · monetizing the debt...

Monetizing the DebtDaniel L. Thornton

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ONETIZING the debt” conjures up fearsomeimages of excessive money stock growth resultingfrom Federal Reserve purchases of Treasury debt.Many analysts fear that debt monetization may pro-duce undesirable economic consequences, such asmore rapid inflation and, thus, higher nominal inter-est rates. There appears to be some confusion, how-ever, over what debt monetization means, whether orto what extent the Federal Reserve has pursued apolicy of debt monetization in the past and what thebest indicator of debt monetization is. ‘these ques-tions ar’e of intense interest, with potentially large def-icits looming on the horizon that could put increasedpressure on the Federal Reserve to monetize the debtin the future.

The puipose of this article is to clarif the meaningof the phrase “monetizing the debt” and to determinewhether the Feder-al Reserve has monetized the debtsince 1960. As we will see, the policy objectives of themonetary authority play an important i-ole in deter-mining whether’ the Feder-al Reserve will monetize thedebt, We also will show that car-c must be taken not toconfuse debt monetization with growth in the FederalReserve’s portfolio of government debt.

MONETIZING THE DEBT:WHAT DOES IT MEAN?

In lar’ge measure, the phrase “monetizing the debt”grew out of the experience of the Federal Reserve im-mediately after World War It. At the time, the FederalReserve had a tacit commitment to the U.S. Treasury to

Daniel L. Thornton is a senioreconomist at the FederalReserve Bank ofSt. Louis. John C. Schulte provided research assistance.

stabilize the Treasury’s cost of financing the war’ debt.After the war, individuals began liquidating their’ hold-ings of Liberty Bonds. Because of its agreement withthe Treasury, the Federal Reserve purchased substan-

tial amounts of govei-nment debt.’

These purchases increased the reserves of the bank-ing system and, consequently, the money stock; theFederal Reserve was said to have monetized the debt.In March 1951, the Federal Reserve and the Treasuryreached an accor-dwhereby the Federal Reserve estab-lished its independence.2 Since then, the Federal Re-

serve has been free to pur’sue its policy objectivesindependent of the debt financing needs of the‘rr’easury?

With the net federal debt (NFDI — total debt minusholdings of government agencies and tr’usts — atnearly $1.3 tr-illion arid with historically high deficits,in both nominal and r’eal terms, there is concern thatthe rapidly rising debt will put upward pressur’e oninterest rates, inducing the Federal Reserve to in-

‘The Federal Reserve’s holdings of government debt more thantripled from 1943 to 1946. See Historical Statistics of the UnitedStates (1975), p.1116.

2See Ahearn (1963), pp. 16—21,3Actually, at a more abstract level, the question of the independenceof monetary and fiscal policies is open to debate. Sargent andWallace (1981) use the government budget constraint to argue thatthe monetary authority must ultimately monetize deficits, This argu-ment has been challenged recently by Darby (1984), and someevidence has been supplied recently by Barth, Iden and Russek(1984). Furthermore, the budget constraint can be used to arguethat the seignorage associated with Federal Reserve open marketoperations requires a compensatory change in government expend-itures or taxes. This latter point is discussed in Horrigan (1983). Theseignorage associated with open market operations is easily illus-trated from the budget constraint suggested by Thornton (1984).

30

FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1984

crease the monQv supply more rapidly than it other-wise would or, perhaps, should!

Today, as in the immediate post-World War II pe-riod, the phrase “monetizing the debt” means moneygrowth induced by attempts to moder’ate the effects ofrapidly growing gover-nment debt on interest rates. Bydefinition, open mar’ket operations buying and sellinggovernment securities in the money and capital mar-kets) represent debt monetization, that is, the replace-ment of government debt with money. Open mar’ketpurchases and debt monetization, therefore are oftentaken to be synonymous! This view is enhanced bythe fact that open maiket operations are usually con-sider-ed the principal tool through which the FederalReserve influences the money supply, so that changesin Federal Reserve policy are likely to be reflectedinitially in its portfolio of government debt. For thesereasons, analysts sometimes look at the growth of theFederal Reserve’s portfolio of government debt, theratio of the Federal Reserve’s holdings of debt IFHDI toNFD, or similar measures as indicators ofdebt moneti-zation. These measures, however, give too little atten-tion to the goals of policy and the nature of the moneystock mechanism.’

It is clear fr’om our definition that debt monetizationcannot be analyzed separately from the objectives ofFederal Reserve policy. Assume, for example, that theFeder’al Reserve is targeting money growth to achieveprice level stability. Furthermore, assume that r’eal in-come is growing at a faster r’ate than velocity so thatmoney growth must be positive. If this money growthis achieved through open market purchases of govern-ment debt while the debt is simultaneously increas-ing, the cor’relation between the growth in the FederalReserve’s portfolio and government debt gi’owthwould give the false appearance of debt monetization.7

In this example, debt monetization actually occurs

4See Tatom (1984) for a historical survey of the deficit.‘In principle, any debt can be purchased. In practice, however, theFederal Reserve primarily purchases marketable debt of the U.S.Treasury.

‘These measures are singled out here because they are most fre-quently used in the popular press. Other measures, such as growthof total reserves or the monetary base, suffer from this same defi-ciency, as well as some of the deficiencies noted in the followingdiscussion. See Blinder (1983), Dwyer (1984) and Barth, Sicklesand Wiest (1982) for examples of the various measures that havebeen employed in empirical studies of this question.

‘The astute reader will recognize that this implies that open marketpurchases of debt are not strictly required for debt monetization tooccur. This can be argued in a number of ways. At a rudimentarylevel, assume that the Treasury has the power to print money, sothat deficits can be financed either by issuing debt or, as a substi-tute, printing money. Printing money directly is as much debt mone-

only if the Federal Reserve modifies its primary objec-tive of price stability because it fears that debt growthwill boost interest rates.

Fur-thermore, in order to claim that the Federal Re-serve has monetized the debt, one would have to ar-gue both that ther’e is a positive relationship betweenactual or anticipated interest rates and debt growthand that the Federal Reserve had modified its primarymoney stock growth objective in response to actual orperceived upward pressure on interest rates. In thisinstance, the association between the difference in theactual and targeted growth rates of money and thegrowth of NFD would provide evidence of debt mone-tization.’ Thus, using the growth of Ff10 or the ratio ofFF10 to NFD alone as indicators of debt monetizationcould be misleading. If the Federal Reserve achieves itsdesir’ed money gr’owth objective, it is nor monetizingthe debt, even if money growth is achieved solelythrough open market purchases of government debt.

Alternatively, suppose the Federal Reserve’s inter-mediate policy objective is to peg interest rates atsome desired level.” Then the Federal Reserve mone-tizes the debt only when changes in the debt, ceterisparibus, produce changes in interest rates in the samedirection. That is, if increases in the debt put upwardpressure on interest rates, the Federal Reserve willmonetize the debt under an interest rate target.

OBSTACLES TO IDENTIFYING DEBTMONETIZATION

In addition to the need to account for the explicit orimplicit targets of monetary policy, there is another’consideration that makes the growth of FF10, the ratio

tization as if debt were first issued to finance the deficit, then repur-chased (later) through note issue.

Of course, the Treasury cannot issue notes directly. Indeed, theFederal Reserve cannot even purchase government debt directlyfrom the Treasury. Consequently, all deficits must initially be fi-nanced through debt issue. This initial debt issue increases thedemand for credit. If this drives interest rates upward, the FederalReserve can lessen the effect by increasing the supply of credit,using any of its policy tools. The long-run effects of Federal Reserveactivities, however, depend on the tool used due to possible wealtheffects and the seignorage associated with open market operations.See Thornton.

‘This does not imply that the Federal Reserve has the ability to hit itsmoney target exactly. It requires only that there be a systematicrelationship between these errors and debt growth. The identifica-tion of this process could be complicated, however, if the uninten-tional errors are associated directly or indirectly with debt growth.

‘It is difficult to conceive of a situation in which the Federal Reservecould control interest rates in anything but the short run; neverthe-less, this is acommon conception of the transmission mechanism ofmonetary policy.

31

FEDERAL RESERVE SANK OF Si’. LOUIS DECEMBER 1984

of FF10 to NFD and similar measures even less reliableas indicators of debt monetization: money growthdoes not necessarily require growth in the FederalReserve’s portfolio ofgovernmefl securities. Thus, thelink between debt monetization and the growth ofFF10 may be much weaker than commonly imagined.

Consider the simple model of money growth,

where the growth of money, rCi, is the sum of thegrowth of the money multiplier’, rh, and the growth ofthe adjusted monetary base, E. Ifadjusted base growth

were achieved entirely through open market opera-tions and if the multiplier- were constant i.e., mh =money growth would be equal to the growth in theFederal Reserve’s portfolio of government debt. If themultiplier’ were rising, however, money growth wouldexceed portfolio growth; if the multiplier were falling,portfolio growth would exceed money growth. There-

fore, the extent towhich the Federal Reserve is mone-tizing the debt cannot be determined simply ~w ob-serving the growth rate of the Federal Reserve’sportfolio of government securities. Multiplier move-ments must be considered because such movementsweaken the link between portfolio growth and debtmonetization.

Base Growth and Debt Monetization

Other factors affect the link between adjusted baseand portfolio growth and, thereby, make the connec-tion between debt monetization and the growth of theFederal Reserve’s portfolio even more tenuous. Even ifthe multiplier is constant, the growth rate of moneyneed not correspond closely with growth in the Fed-end Reserve’s holdings of government debt.

One of these factors is changes in reserve require-merits, such as those mandated by the Monetary Con-trol Act of 1980. These reserve requirement changesare reflected in the reserve adjustment magnitude(RAM).” Increases in RAM increase the base, whilereductions reduce it. Consequently, changes in RAMma cause the Federal Reserve to buy more or less

government debt than it otherwise would to achieveits monetary growth objective under a monetary tar-geting procedur-e.

Adjusted base growth also is affected by other’ fac-tors, such as depository institution borrowing from

“See Tatom (1980) for a discussion of the adjusted monetary basEand RAM.

the Federal Reserve and Federal Reserve float.” Secu-lar movements in these factors can result in adjustedbasegrowth that is faster or slower than the growth ofthe Federal Reserve’s portfolio. Consequently, data onthe growth rate ofthe Federal Reserve’s portfolio isnotnecessarily a good indicator of the extent to which the

Federal Reserve is monetizing the debt.

An Illustration of These Relationships

The importance of these factors is illustrated incharts 1—4. Chart I shows the ratio of FH0 to NF0annually from 1960 to 1983. This ratio increased from1960 to 1974 and declined thereafter. Thus, generallyspeaking, the Federal Reserve purchased governmentsecurities at a more rapid pace than the growth of NFDup to 1974, but at a much slower pace afterwards. tfthis ratio were used as the sole indicator of debt mon-etization, one would likely conclude that the FederalReserve monetized the debt from 1960 to 1974, thenreversed this policy.

The same conclusion would emerge if only thegrowth r’ate of the Federal Reserve’s portfolio wereconsidered.” Yet Ml growth was about 4.8 percentduring the former period and about 7.2 percent duringthe latter period. Thus, the growth of money wasslower’ in the first period than in the second, despitethe fact that growth of Ff10 was faster in the firstperiod than in the second, both in absolute terms andrelative to the growth of NF0.

This inverse i-elation can be explained, in large part,by movements in the money multiplier, RAM, deposi-tory institutions’ borrowings and float. These seriesare presented in charts 2-4.

The multiplier declined more or less steadilythrough 1974. Over- the same period, RAM was fairlystable, flr’st rising then dropping slightly. Borrowingwas fairly stable through 1972, then increased dramat-ically in 1973—74. Float increased modestly through1972, then declined by about $1 billion during 1973

and 1974. On net, a modest amount of monetary basewas supplied to the banking system fiom 1960 to 1974through bor-rowings and float, while RAM drained amodest amount of monetary base from the system

over this period. With the exception of borrowingsduring 1973—74, however-, none of these factors was

“There are other factors that affect base growth; however, quantita-tively they are typically less important than those noted.

“The compounded annual rate of growth of FHD was 6.89 percentfrom 1974—83, compared with 8.23 percent from 1 g60—74.

32


Chart I

Ratio of Federal Reserve Holdings of Federal Debtto Total Debt

Annuel data

196061 6263 64 65 666768 6910 71 72 7374 75 7677 78 798081 821983

the decline in theparticularly large relative to

multiplier.’’

Consequently, even if the policy objective had beenzero money growth, the Federal Reserve still would

have had to make substantial net open market pur-chases of government securities to offset the decline inthe multiplier’. Thus, the increase in the ratio of FF10 to

NF0 might reflect nothing more than the Federal Re-serve’s need to make purchases of government debt(to offset multiplier movements) in excess of thegrowth of NF0 over this period.

After 1974, a number of factors reduced the Federal

Reserve’s need to engage in open market purchases.There was asignificant increase in RAM through 1974—

78, followed by an even more dramatic r’ise after the

“For example, the multiplier declined from 3.13 in 1960 to 2.78 in1974. Given the average level of the adjusted monetary base of$64.82 billion over this period, the decline in the multiplier had animpact equivalent to a $7.64 billion drain on the adjusted monetarybase on average over this period.

Monetary Control Act of 1980. At the same time, both

borrowings and float increased dramatically through1975—79, then declined through 1983. while the multi-

plier- continued to decline through 1980, the rate ofdecline was more moderate than before. Since 1980,the multiplier has remained relatively unchanged. It iseasy to see how money growth could have acceleratedsince 1974 even though the ratio of FF10 to NF0 has

fallen.’4 Thus, the growth of FHD could be used as anindicator of debt monetization only if these other’ fac-tors affecting money remain unchanged.

“No attempt is made here to explain why the various changes in themultiplier, RAM, the float or borrowings occurred. Nevertheless,some of these changes can be readily explained. For example, theincrease in borrowings in 1974 was due, in part, to the FederalReserve’s efforts to shore up the banking system after the collapseof the Franklin National Bank (see the Board of Governors of theFederal Reserve System 11974], pp. 740—41). Likewise, the signifi-cant jump in RAM after 1980 can be attributed directly to the Mone-tary Control Act of 1980, while the significant decline in the float after1979 is associated with Federal Reserve efforts to improve thecheck-clearing process.

RatioiS

Ratio

.25

.20

.15

.10

.20

.15

.10

33

3.0

2.8

2.6

2.41960 61 62 63 64 65 66 67 68 69 70 11 72 13 74 75 76 71

Ratio

— 3.2

30

2.8

2.6

— 2.478 79 80 81 82 1983

Actually, it would be legitimate to use the growth ofthe PHD as an indicator of debt monetization if theFederal Reserve established it as an intermediate pol-icy target. Since this has never been done, the possibil-ity is not considered here.’3

A Note on the Interest Rate andLiquidity Effects

The reader is cautioned that this analysis is an illus-tration of debt monetization under the usual textbook

description of countercylical monetary policy. Assuch, it and the empirical analysis that follows areheavily dependent on the existence of two effects thatfind little support in empirical studies.” The first is theeffect of changes in the government debt on interest

“During the period from October 1979 to October 1982, the FederalReserve used nonborrowed reserves as an operating target. Moneygrowth, however, was its intermediate policy target.

“For evidence on the liquidity effect, see Brown and Santoni (1983),Melvin (1983) and the references cited in these articles. For evi-dence on the relationship between debt growth and interest rates,see Evans (1984), Blinder and the references cited in Blinder.

rates. The story of debt monetization told above restson the idea that increases in debt issue by the Trea-sury raise the demand for- credit relative to the supply;consequently, interest rates rise. While it is beyond thescope of this article to delve into these arguments.some economists believe, and the bulk of empiricalwork suggests, that increases in debt have no effect oninterest rates. If this is true, then increases in debtwould not put pressure on the Federal Reserve tomonetize under any policy regime — unless, ofcourse, the Federal Reserve believes that debt in-creases cause interest rates to rise.

The second effect implicit in this analysis is the so-called liquidity effect, an initial decline in interestrates associated with an unexpected acceleration inthe growth rate of money. While the liquidity effect hasbeen isolated empirically, estimates suggest that it isweak and short-lived. The evidence further’ suggeststhat the longer-run effect of acceler’ated moneygrowth is higher, not lower, nominal rates of interest.If the Federal Reserve believed this, it would be con-siderably less anxious to monetize debt increases, re-

Chart 2

Money MultiplierRatio3.2 -

Annual dateSeasonally adjusted

N

~•%.__

~N~_—

\

~— -,~

34

chart 3

Reserve Adjustment Magnitude (RAM) and FloatDepository Institutions

Annual dataBillions of dollars Seasonally adjusted

0

7-6 -

196061 6263 64 65 666768 69 70 71 72 73 74 75

chart 4

Total Borrowings at Federal Reserve BanksAnnual data

Billions of dollars Seasonally adjusted —

2.5Billions of dollars

2.5

AI

I

;

I I I

J

F I I

/

I

Th

I I196061 62 6364 65 66 6768 6970 71 7273 74 75 76 77 78 798081 821983

1.0

at

Billions of dollars

12

6

Float

—~

7~/ N

I /RAK~)

12

6

0

-676 77 78 79 80 81 82 1983

2.0

1 S

1.0

.5

.0

2.0

13

.5

.0

35


alizing that the longer-run consequences of its actionswould be higher inflationand higher nominal interestrates.

WHAT IS THE EVIDENCE ON DEBTMONETIZATION?

Ideally, to determine whether the Federal Reservehas monetized the debt, deviations between actualand desired monetary targets (say money growth)should be compared with debt growth. Practical con-siderations make such a comparison difficult. If theFederal Reserve established target rates for the growthof money that were changed infrequently, the growthrate of money might represent a useful proxy for thedeviations between actual and desired money growth.Unfortunately, during most of the post-accord experi-ence with countercyclical monetary policy, the evi-dence suggests that the Federal Reserve seldom fo-cused exclusively on a monetary aggregate target.

Instead, the Federal Reserve has given considerableemphasis to interest rates as the primary intermediatepolicy target. Only during the past 15 years has theFederal Reserve given monetary aggregates much ex-plicit attention. In January 1970, the Federal OpenMarket Committee IFOMC) expressed a desire to placeincreased emphasis on the growth of certain mone-tary aggregates, but explicit targets for the aggregateswere not established until 1975. From October 1979 toOctober 1982, the FOMC emphasized the growth ofthe monetary aggregates even more; however, theweight given to the various aggregates changed overthis period. Consequently, it is difficult to find an ex-tended period over which monetary polity objectivesare sufficiently stable to draw strong inferences aboutwhether the Federal Reserve has monetized the debt.Despite these difficulties, we provide some evidence,which should be regarded as descriptive, of the rela-tionship between money growth and debt growthduring the past two and one-half decades.

The empirical investigation undertaken here differsfrom the usual procedure, which is to estimate a “Fed-eral Reserve reaction function.” The reaction functionis an equation that presumably represents the FederalReserve’s response to variables affecting its policy de-cisions. Studies that have used this type of equationhave produced inconclusive results and suffer from

two problems.”

“For a more precise definition and a review of some of the empiricalliterature, see Dwyer. For other reviews of empirical studies, seeBlinder and Barth, Sickles and Wiest.

First, many of these studies have used reserve orbase growth as the monetary policy variable. Since theevidence suggests that the Federal Reserve has nevertargeted explicitly on these variables, changes in thegrowth rates ofthese variables should not be relied onto provide evidence of debt monetization.

Second, these studies include only contemporane-ous values of both the monetary policy variable andthe measure of federal debt growth. Since these var’ia-bles are considered only simultaneously, it cannot bedetermined whether monetary growth causes debt

growth or vice versa. The causation r-unning frommoney to debt is likely because money growth affectsprices, output and nominal interest rates which, inturn, feed back to debt growth.” Of course, no statisti-cal procedure can establish causality. There is an eas-ily implemented procedure, however, which can beused to test for the temporal ordering of two or morevariables. The procedure is called a test of (irangercausality.”

The Test Procedure

This test procedure can be illustrated by using thegrowth rate of M and NFD. Let M, and NED, denote thegrowth rates of money and the net federal debt, re-spectively, in the current period and let rCt,, ~NED,~,NED.,..., denote values of these variables inprevious periods. The test for Gr’anger causality run-ning from rct to NED amounts to regressing the currentvalue of NED on past values of itself and ra, and testingthe hypothesis that all of the coefficients on the pastvalues of M are zero. To test that Granger causality

runs from NED to rGt, the current value of r~iis re-gressed on previous values of itself and NED, and thehypothesis that the coefficients on the past values ofNED are zero is tested. If the latter hypothesis is re-

jected, while the former is not, then it is said thatgrowth of the NFD Granger-causes (temporally pre-cedes) money growth. If the former is rejected, whilethe latter is not, then money growth is said to Granger-cause ltemporal~precede) growth of the NFD. Ifbothare rejected, no temporal ordering can be establishedli.e., there is feedback between rCt and NED). Ifneithercan be rejected, the series are not temporally related(i.e., they are said to be independent;.

“See Dewald (1984), Carlson (1984) and footnote 3.“Friedman and Schwartz (1963) were among the first to try to estab-

lish the temporal ordering between macroeconomic variables. De-spite its name, it is now recognized that this procedure is not literallya test of causality, nor is it a test of statistical exogeneity. See Zellner(1979) for a discussion of causality, and see Jacobs, Leamer andWard (1979) and Wu (1983) for a discussion of the relationshipbetween Granger causality and statistical exogeneity.

36


Tests of Granger causality were performed over thel/1960—IV/1983 period using two measures of debtgrowth that have been used in the reaction functionliterature. The first is the growth of NFD, discussedearlier. The second is the high-employment budgetdeficit (HEBDL” The deficit and changes in the NFDdiffer by the so-called off-budget items. These itemsare omitted from the official reports of the deficit,despite the fact they require debt issue.

In addition, the changes in the NFD and the HERDdiffer in that the latter is adjusted for cyclical factors,while the former is not. Consequently. changes in NFDmay misrepresent the pressure to monetize the debtbecause they are not cyclically adjusted. In otherwords, a given change in NFD is likely to be associatedwith amuch smaller effect on interest rates ifit occursin the contraction rather than the expansion phase ofthe cycle.

Furthermore, since a relatively larger portion ofdeficits are cyclically induced, these cyclical in-fluences may be dominant!’ If these cyclically in-duced changes in debt are not associated with risinginterest rates, there is no pressure to monetize thedebt. Thus, because the cyclical effects have not beencontrolled for, there may be no temporal orderingrunning from NFD to money. Changes in moneygrowth, moreover, have been shown to induce cyclicalswings in economic activity, so we should not be sur-prised to find a strong effect running from money toincome to NFD. To account for the effects of cyclicalfactors, lags of output growth and lags of the inflationrate are included in some of the tests of Granger cau-sality!2

The advantage of using the HERD is that it is ad-justed directly for cyclical factor’s. It too may misrepre-sent the pressure to monetize the debt, however, be-cause the off-budget items are omitted. Consequently,

it may be significantly smaller than the amount of debt

‘°Thedata for HEBD ends in 111/1983, so the tests of Granger causalityinvolving this variable were performed over this shorter period. Al-though there are other ways to carryout these tests, work by Ge-weke, Meese and Dent (1983) and Guilkey and Salemi (1982)indicate that the procedure used here is preferred.

“See Tatom (1984).

“Lags of past inflation are includedbased on the finding reported byBlinder and on the work of Horrigan and Protopapadakis (1982) andothers who find that much of the measured deficits are relateddirectly to inflation. It could also be argued that the lag from moneygrowth to inflation is long. Therefore, the lags of past inflation maysimply be a proxy for even longer lags of money growth.

In addition to NFD, a relatively new measure, the cyclically ad-justed federal debt calculated by deLeeuw and Holloway (1983),was used. The qualitative results with this variable were unchangedfrom those using NFD, so they are not reported here.

issue.23 Furthermore, since the HERD is cyclically ad-justed, changes in past output should not affect testsof Granger causality running from money to HERD;past changes in prices, however, may affect these tests.

Finally, because the question of debt monetizationis tied closely to the policy objectives of the Federal

Reserve, it is important to take account of these policyobjectives. Thus, the tests of Granger causality wereconducted over the entire period 111960—tII/1983 andover the subperiod ttt/1972—tlI/1983, during which atleast some consideration was given to money stockobjectives.” Because of the shortness of this period, it

was necessary to restrict the search to six lags on eachvariable and to include only three lags of outputgrowth and inflation.

Empirical Results

The Granger causality tests were performed onquarterly growth rates of Ml and NFD and on thequarterly growth rate of Ml and HERD, following aprocedure outlined in Thornton and Batten (1985)?The significance levels corresponding to the calcu-lated F-statistics of the Granger tests are reported intables 1—B.” The significance levels are presented be-cause the significance of the F-statistics vary with the

“For example, thechange in NFD in fiscal 1983 of $202.8 billion wasmade up of a $188.8 billion on-budget deficit and a$14.0 billion off-budget deficit. See Economic Repo,t of the President (1983). Also,see Allen andSmith (1983).

“The FOMC stated its desire to place increased emphasis on certainmonetary aggregates at its January 1970 meeting; however, theestimation period begins in Ill/i 972 to be conservative and to allowfor the six lags of both variables.

“The fact that these tests ignore the question of whether changes inthe debt affect market interest rates is particularly important in inter-preting the results. If changes in debt have no effect on interestrates, we should not expect to find atemporalordering running fromdebt growth to money growth. If changes in debt have an effect, wemay or may not find such a temporal ordering. Thus, the lack of atemporal ordering running from debt to money growth could resulteither from a lack of an interest rate effect or from a refusal on thepart of the Federal Reserve to monetize the debt.

Furthermore, in a rational expectations view, the Federal Reservemight anticipate the deficit and increase money growth in advanceof the actual increase in the debt. In this case, money growthmightprecede debt growth, but we find no evidence of this temporalordering.

“Tests of Granger causalityshould be conductedwith time series thatare covariance stationary. When the autocorrelation functions ofMl, NED and HEBD were investigated, the series appeared station-ary. When the Granger causality tests were undertaken including atime trend, however, the trend variable wasalwayssignificant at the5 percent level, suggesting that the series arenot stationary. Whenthe tests were performed on first differencesof Ml, NED andHEBD,the time trends were uniformly insignificant. With one exceptionnoted below, however, these results were not qualitatively differentfrom those using the growth rates of Ml and NFD and the level ofHEBD. The latter results are reported because they are easier tointerpret.

37


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degrees offreedom. The outcomes that are significantat the 5 percent level are denoted by an asterisk. For’example, in the regression ofNil on NED in table I theentry for three lags on each variable is .047. This mdi-cates that the hypothesis that NED does not Gr’anger--cause Ml can be i-ejected at the 5 pet-cent significancelevel for this lag specification. When the lag length is

increased to four’, however, this hypothesis cannot berejected because the entry, .269, is greater’ than .05.

The significance levels based on simple bidirec-tional tests ofGr’anger causality between KU and NEDand fCll and HERD are presented in tables 1 and 2,r-espectively. The r’esults in table 1 indicate a str’ong

unidir’ectional effect running from Ku to NED. onlyseven ofthe 144 F-tests for the influence of NED on ~li

reported were significant at the 5 per’cent level. None

of these seven lag structures, however, was chosen bya comnionly used lag-length specification criterion.”Because NF’D is not cyclically adjusted and is likely tobe affected by changes in r’eal output and prices in-duced by changes in the money supp~, it is not toosur’pr’ising that the teniporal or’dering runs fi’onl Ml toNED.”

“The lag-length selection criterion used here is the final predictionerror. See Thornton and Batten, and Batten and Thornton (1984).

“It is somewhat surprising, however, that the same qualitative resultis obtained for the cyclically adjusteddebt measure. This suggeststhe possibility that this cyclically adjusted measure does not captureall the effects of past output and price level growth. This conjectureis supported by the fact that the significance levels are greatlyincreased when three lags of output growth and inflation were in-cluded in these specifications. In anyevent, there is no evidenceof atemporal ordering running from cyclically adjusted debt to money.

38


4 /24/2 ~ ~ t:22424: ~ ~ ~ 2~42,24s~2422\2 ~ 2~ 2242

2 ~ , ~ 24/ ‘

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~ t

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/2 ~2

- /2a

7

/2-

9—

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- a 24/2 224~

2 4/

, /2/2/ /

2 2 /24

2 4

2 /2 4/

4 4 4 42/

A ~ / /44 2/2 ~ \2

/2 24 /2 2/ ~C ~t /2~42$ ~ 8t ~~ 4 /22~ : ~ ~ \4\ 4 ~ t~~Asscaw44:t~

4~// ~ /2 $!‘~ ~ ~ 2/ s:ap~: ~ 2~41~2$~

tt/2as147 / 44

/4 4 ~ PF~$~.2/~/

~ 2 ~~:i 744~%24~ ~ ~ ~ /24~ :t2> 4: ~ ~ /2/ /22 ~ 2/24/:-~~rN442442~%Q~2~24~ :~4~44~t~4/<The results in table 2 for the HERD, however, mdi-

cate unidirectional causality running from HERD toMl. The hypothesis that HERD has no impact on Mlwas rejected for nearly every lag specification consid-ered, while the hypothesis that r~tlhas no effect onHERD was never r’ejected. Thus, this measure suggeststhat money gr’owth responds to cyclically adjustedchanges in the debt.

The Granger Tests Extended forCyclical Influences

In the simple tests of bivariate Granger causalitypr’esented above, the observed feedback betweenmoney growth and NED or’ the causality running from

HERD to K41 could be the result of the close associa-tion between these variables and factors not ac-

counted for by the equation. In order to guard againstthis possibility, the tests were repeated adding threeand then six lags of the growth rates of prices and realoutput as additional variables.”

The results for the equations with six lags are pre-sented in tables 3 and 4. The results in table S indicate

“The possibility that money growth responds to either past outputgrowth or inflation can be argued two ways. First, such variablescouldrepresenta FederalReserve reaction function response, e.g.,high past rates of inflation or output growth inducethe Fed to slowthe rate of Ml growth. Second, themoney supply couldbe endoge-nous (at least overshort periods oftime like aquarter), i.e., related toother variables in the system like interest rates. Since interest ratesare positively related to both inflation and output growth, the moneystock should move with these variables. If the second case werecorrect, there should be a positive relationship between past infIa-tion and money growth; however, Blinder reports a negative rela-tionship. We find the same result, although it is not reported here.

39


2 ~

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/

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~ / / 4 / >4444/>///$/ >2 >2 >>>> >2/> 44’> >> /44/ ‘2>> >>1

that Ml and NED ar-c independent series. There rn-cjust seven instances wher’e the F-tests of NEI) on ~11ar’e significant, and none of these were selected by thelag-length specification criterion.” Thus, once outputgrowth and inflation are accounted fo,-, ther-e is virtu-ally no evidence of a separate effect of money growthon debt growth and no evidence of causality from NED

to Ml.

The results in table 4 are similar to those in table 2,in that ~Il has no effect on HERD, while HERD con-tinues to Granger-cause r~ll.A comparison of tables 2and 4, however, shows that the significance levels for

“When first differences of growth rates are used, there is no area ofthe lag space where the hypothesis can be rejected.

the tests of the effect r’unning fi-om HERD to Ml ar-csubstantially larger when gr’owth r-ates of output andpr-ices are accounted for. Nevertheless, the HERD pro-

tides some evidence of debt monetization not evidentwhen NED is used.

Results for Ill/i 972 —IV/i 983

The results for the 111/1972—111/1983 period> in whichmore emphasis was placed on the monetary aggre-

gates, ar’e reported in tables S and 6. UnIv the resultswith lags of inflation and output gr’owth are re-ported.l” These results indicate that, over this period,

“When no lags of inflation and output growth are used, the resultsindicate unidirectional causality running from Ml to NFD and inde-pendence between Ml and HEBD.

40


Ku is independent of both NED and the HERD. Therewas no por-tion of the lag space consider’ed in whichthe hypotheses constituting the Granger’ tests couldhe rejected. Hence, ther-e is no evidence of debt mone-tization ovet- this per-iod for’ either’ measure of debtgrowth. Thus, the HERD result, which indicates thatthe Federal Reserve had monetized the debt over the1960—83 period, appear’s to result from the Feder’alReserve’s interest rate tar-get procedures over nearlythe first half of the period — a period when debtmonetization is mor’e likely to be an inherent result ofattempts to influence inter’est rates. An investigation ofa period for which it is more relevant to consider thequestion of debt monetization yields no evidence thatthe Feder’al Reserve has monetized the debt.

The pur-pose of this article was to clear up confusionthat often char’acterizes discussions ofdebt monetiza-tion and to provide some evidence on the question ofwhether the Federal Reserve has monetized the debt.Specifically, it was pointed out that the phrase mone-tizing the debt” means money growth in excess ofthatrequired to achieve some policy objective that is in-duced by rapid growth in the federal debt.

It was noted that the r’atio of Federal Reserve debtholdings to net federal debt, or other such measures,

cannot be used alone as evidence of debt monetiza-tion. Changes in the money multiplier’ and factor’s that

affect components of the monetary base will influence

CONCLUSIONS

41


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I/2

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4~~er>>52~ 2’

~ a$èa . > /22>4774>4 ~>> , > — >.It~~H~s>7Ht H~ >> . - >

42


the growth of the Federal Reserve’s portfolio ofgovern-ment securities for any given policy objective in waysthat confound attempts to determine the extent ofdebt monetization taking place.

‘Two commonly used measures of debt growth, the

growth of net federal debt and the high-employmentbudget deficit, were used to test whether moneygrowth precedes debt growth, or vice versa. The

results for the tlt/1972—IV/1983 period, during whichthe Federal Reserve placed more emphasis on themonetan1 aggregates than it had in previous years,shows no evidence of debt monetization by the Fed-

eral Reserve using either debt measure. For the entire1960—83 period, there is evidence of debt monetization

for the high-employment deficit measure, but not forgrowth of the net federal debt. Thus, the only evidenceof debt monetization occurs during the period of in-terest rate targeting, when debt monetization is to be

expected if increases in the federal debt put upwar’dpressure on interest rates.

The reader is cautioned, however, in that actualmoney growth, rather than deviations of actual fromdesired money growth, was used in these tests. Since

the debt monetization has to do with movementsaway from policy objectives induced by actual or per-ceived pressure of rapid debt growth on interest rates,the critical implicit assumption here, and in most pre-vious studies of debt monetization, is that actualchanges in money growth proxy such movements.

REFERENCES

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Allen, Stuart D., and Michael 0. Smith. “GovernmentBorrowing andMonetary Accommodation,” Journal of Monetary Economics (No-vember 1983), pp. 605—16.

Barth, James R., George den and Frank S. Russek. “The Eco-nomic Consequences of Federal Deficits: An Examination of theNet Wealth and Instability Issues,” processed (1984).

Barth, James R., Robin Sickles and Philip Wiest. “Assessing theImpact of Varying Economic Conditions on Federal Reserve Be-havior,” Journal of Macroeconomics (Winter 1982), pp. 47—70.

Batten, Dallas S., and Daniel L. Thornton. “How Robust Are thePolicy Conclusions of theSt. Louis Equation?: Some Further Evi-dence,” this Review (June/July1984), pp. 26—32.

Blinder, Alan 5. “On the Monetization of Deficits,” in Laurence H.Meyer, ed. The Economic Consequences of Government Deficits(Kluwer-Nijhoff, 1983), pp. 39—73.

Board of Governors of the Federal Reserve System. “Announce-ments,” Federal Reserve Bulletin (October1974), pp. 740—41 -

Brown, W. W., and 0. J. Santoni. “Monetary Growth andthe Timingof Interest Rate Movements,” this Review (August/September1983), pp. 16—25.

Carlson, Keith M. “Money Growth and the Size of the FederalDebt,” this Review (November 1984), pp.5—16.

Darby, Michael A. “Some Pleasant Monetarist Arithmetic,” FederalReserve Bank of Minneapolis Quarterly Review (Spring 1984), pp.15-20.

deLeeuw, Frank, and ThomasM. Holloway. “CyclicalAdjustment ofthe FederalBudget and Federal Debt,’ Survey of Current Business(December 1983), pp. 25—40.

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Geweke, John, Richard Meese and Warren Dent. “Comparing Al-ternative Testsof Causality in Temporal Systems: Analytic Resultsand Experimental Evidence,” Journal of Econometrics (February1983). pp. 161—94.

Guilkey, David K., and Michael K. Salemi. “Small Sample Proper-ties of Three Tests for Granger-Causal Ordering in a BivariateStochastic System,” The Review of Economics and Statistics (No-vember 1982), pp. 668—80.

Historical Statistics ofthe United States: Colonial Times to 1970, part 2.(GPO, 1975).

Horrigan, Brian R. “Pitfalls in Analyzing Deficits andInflation,” Fed-eral Reserve Bank of PhiladelphiaWorking Paper No.83-4(1983).

Horrigan, Brian R., and A. Protopapadakis. “Federal Deficits: AFaulty Gauge of Government’s Impacton Financial Markets,’ Fed-eral Reserve Bank of Philadelphia Business Review (March/April1982), pp. 3—16.

Jacobs, RodneyL., Edward E. Leamer and Michael P. Ward. “Diffi-culties with Testing for Causation,” Economic Inquiry (July 1979),pp. 401—13.

Melvin, Michael. “The Vanishing Liquidity Effect of Money on Inter-est: Analysis and Implications for Policy,” Economic Inquiry (April1983), pp. 188—202.

Sargent, Thomas J., and Neil Wallace. “Some Unpleasant Mone-tarist Arithmetic,” Federal Reserve Bank of Minneapolis QuarterlyReview (Fall 1981), pp. 1—17.

Tatom, John A. “A Perspective on the Federal DeficitProblem,” thisReview (June/July 1984), pp.5—17.

“Issues in Measuring An Adjusted Monetary Base,”this Review (December1980), pp. 11—29.

Thornton, Daniel L. “The Government Budget Constraint with En-dogenous Money,” Journalof Macroeconomics (Winter 1984), pp.57—67.

Thornton, Daniel L., and Dallas S. Batten. “Lag-Length Selectionand Granger Causality Between Money and Income,” Journal ofMoney, Credit and Banking (forthcoming, May 1985).

Wu, De-Min. “Tests of Causality, Predeterminedness and Exoge-neity,” InternationalEconomic Review (October 1983), pp. 547—58.

Zellner, Arnold. “Causality and Econometrics,” in Karl Brunner andAllan H. Meltzer, eds., Carnegie-Rochester Conference Series onPublic Policy, Volume 10 (Amsterdam: North-Holland 1979), pp.9—54-

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