MONEY SUPPLY IMPLICATIONS OF COMMERCIAL BANKS' FINANCING OF GOVERNMENT DEBT IN DEVELOPING COUNTRIES
| Author | WARREN L. COATS,DEENA R. KHATKHATE |
| DOI | http://doi.org/10.1111/j.1468-0084.1978.mp40002006.x |
| Date | 01 May 1978 |
| Published date | 01 May 1978 |
MONEY SUPPLY IMPLICATIONS OF COMMERCIAL
BANKS' FINANCING OF GOVERNMENT DEBT
IN DEVELOPING COUNTRIES
By WARREN L. COATS, JR. and DEENA R. KRATKHATE*
I. INTRODUCTION
Budget deficits are typically analysed in terms of particular economic conse-
quences, the traditional categories being allocation, distribution and stabilization.'
For various reasons which need not be detailed here, it is felt that for developing
countries the stabilization consequences of budget deficits are most closely related
to their impact on the money supply.2 The money supply can be affected if
deficits are financed by borrowing from a country's central bank or its commercial
banking system. Quite often a single measure of the combined borrowing from
these two sources is used to summarize the stabilization effects of budget deficits.
If financing comes, in the first instance or ultimately, from the central bank, the
expansionary impact on the money supply of a budget deficit is clear and un-
ambiguous. If it comes from the commercial banking system the monetary effect
depends upon the behaviour of certain items like credit to the private sector or
excess reserves in the portfolios of commercial banks and will rarely be the same
as borrowing from the central bank. Therefore the combined measure, net bank
credit to the government, tells us nothing insofar as the money supply impact is
concerned,which information is fullycontained in itstwounaggregated components,
and yet it is a concept sometimes used in monetary and fiscal analysis, particularly
by the LDCs.3
The money supply impact of a deficit depends critically on whether it is
financed by the central bank or by commercial banks. Central bank credit to
government causes money to expand directly by increasing the monetary
* We are very indebted to Mr. Moustapha for collecting the required data and for his
computational assistance and to Delano P. Villaneuva for his helpful comments. Views
contained in this paper are the authors' own and do not reflect those of the International
Monetary Fund where they are presently employed.
1The standard reference is to R. A. Musgrave, The Theory of Public Finance (McGraw-
Hill, 1959). Two important additional references are staff papers and other materials reviewed
by the President's Commission on Budget Concepts (Washington, D.C., 1967); and Raja J.
Chelliah, 'Significance of Alternative Concepts of Budget Deficit', IMF, Staff Papers, Vol. XX,
No. 3 (November 1973).
2Ibid., p. 766.
Typical of this is the statement in the Annual Economic Survey of the Government of
India, which emphasizes net bank credit to the Government as a more useful measure of the
stabilization impact of budget deficits. See also Reserve Bank of India, Report on Currency and
Finance, 1972-73. The distinction between net central bank credit to government and net
banking system credit to government as a measure of budget impact on money supply has been
the subject of lively controversy in India. See Suraj B. Gupta, 'Factors Affecting Money
SupplyCritical Evaluation of Reserve Bank's Analysis', Economic and Political Weekly,
January 24, 1976; N. A. Majumdar, 'Money Supply AnalysisMechanistic and Economic
Explanation', Economic and Political Weekly, February 28, 1976; Deena R. Khatkhate,
'Money Supply Analysis: Shadow Boxing?', Economic and Political Weekly, April 17, 1976;
and S. L. Shetty, V. A. Avadhani and K. A. Menon, 'Money Supply Analysis: Further Com-
ments', Economic and Political Weekly, April 10, 1976.
173
174 BULLETIN
base.4 However if financed by commercial banks the monetary effects depend upon
the behaviour of the money multiplier. If excess reserves are nil or a constant pro-
portion of bank deposits, commercial banks can lend to the government only at the
cost of their credit to the private sector, and hence there will not be any change in
the money supply. It is possible, of course, for commercial banks to increase their
lending to the government without reducing their credit to the private sector, if
the central bank of the country is willing to expand the supply of reserve money to
commercial banks. This might be done by buying up government debt directly
through open market operations or by increasing discounts and advances to banks.
Such an increase in the central bank's supply of reserve money is caused either by
the pressures exerted by the commercial banks and by the government, or by the
central bank's own desire to moderate or offset the effects of government borrowing
on interest rates or on the availability of credit to the rest of the economy. In
such cases, debt financing by commercial banks increases the monetary base and
therefore does increase the money supply. Yet these effects cannot be attributed,
at any rate analytically, to the lending by commercial banks to government per se.
If reserve money expands, it is because the central bank changes its stance
regarding its monetary policy and the government's debt has, in fact, ultimately
been financed by the central bank.
Thus if the commercial banks' credit to government does not influence the
monetary base or it is not at the cost of their credit to the private sector, it must
be at the expense of their excess reserves.5 If banks lend to the government by
drawing down their excess reserves, the value of the money multiplier rises and
consequently the money supply increases. In other words, given the monetary
base, government borrowing from commercial banks will affect the money supply
only if that causes excess reserves to be smaller than they otherwise would have
been.6 The purpose of this paper is to investigate empirically whether budget
deficit finance by commercial banks affects their excess reserve holdings and there-
fore the money supply. The desired, i.e. profit-maximizing, level of excess reserves
is formulated so as to allow commercial bank holdings of government debt to have
an effect. This general formulation is empirically fitted to the data from 15
widely diverse countries in order to ascertain the actual significance of any such
effect.
II. EXCESS RESERVE FUNCTIONS
Government borrowing from commercial banks will increase, decrease or leave
the money supply unchanged as it decreases, increases or leaves their excess
reserves unchanged. Changes in the level of excess reserves are assumed to reflect
It is a consequence of this kind of financing of budget deficits which raises the money
supply during a period of inflation. For the analysis of the phenomenon, see Bijan B. Aghevli
and Mohsin S. Khan, 'Government Deficits and Inflationary Process in Developing Countries'
(mimeograph), International Monetary Fund, 1977.
The effects commercial banks might have as a result of borrowing abroad are treated here
as changes in the base.
6The pattern of government spending out of funds borrowed from banks might alter the
currencyJdeposit ratio and thereby the money multiplier, but it need not concern us here as any
change in the currency/deposit ratio would be independent of the budget's financing.
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