PUBLIC SECTOR BORROWING, THE MONEY SUPPLY AND INTEREST RATES
| Author | Colm Kearney,Ronald MacDonald |
| Date | 01 August 1985 |
| DOI | http://doi.org/10.1111/j.1468-0084.1985.mp47003005.x |
| Published date | 01 August 1985 |
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 47, 3 (1985)
0305-9049 $3.00
PUBLIC SECTOR BORROWING, THE MONEY
SUPPLY AND INTEREST RATES
Co/rn Kearney and Ronald MacDonald
I. INTRODUCTION
The Medium Term Financial Strategy (MTFS) of the Conservative
Government incorporated the assumption of a close relationship
between the public sector borrowing requirement (PSBR), the money
supply and interest rates. A desire to avoid excessive reliance on high
interest rates in pursuit of monetary targets led the authorities to
curtail their borrowing requirement through fiscal restraint. The MTFS
outlined a path for the PSBR which was set to be consistent with
achieving the planned reduction in the growth of the money supply
over the medium term with lower rates of interest. In what follows we
investigate the basis for the view that fiscal policy needs to be 'dove-
tailed' in with monetary targets. More specifically, we consider the
relationship between the PABR, the money supply and interest rates.
Section II outlines the arguments for and against the existence of a
close relationship between these variables. The main argument used to
support the existence of such a relationship has been in terms of port-
folio balance between the stock of money and the outstanding stock of
public sector debt. Although there are theoretical and empirical reasons
for being sceptical about the strength of this argument, there is little
conclusive evidence. In Section III we construct a portfolio balance
model of the UK economy and estimate it on quarterly data over the
period l972(l)-1982(4) using the TheilGoldberger mixed estimation
procedure. Given the authorities' fiscal stance, the model solves for the
money supply, interest rates and the rate of foreign exchange. In
Section IV we simulate the model in order to provide evidence on the
nature of the relationship which exists between the variables under
discussion. The final Section summarizes the paper and concludes that
a major element in the Government's economic and financial policy
seems to be lacking in theoretical foundation and empirical support.
II. THEORETICAL CONSIDERATIONS
The role attributed to fiscal policy in the Conservative Government's
anti-inflation strategy is based upon the proposition that a 'large'
PSBR will induce either an increase in the rate of monetary growth or
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higher rates of interest. Speaking at a conference in January 1980, the
Financial Secretary to the Treasury stated:
the PSBR and the growth of the money supply and interest
rates are very closely related. Too high a PSBR requires either that
the Government borrow heavily from the banks - which adds
directly to the money supply; or, failing this, that it borrows from
individuals and institutions, but at ever-increasing rates of interest,
which place an unacceptable squeeze on the private sector.
ETCSC (1980) p. 21
The rationale to the Government's financial strategy follows that if
monetary control is to be secured at low rates of interest, the PSBR
must be reduced. The remainder of this Section considers the theoreti-
cal basis for the existence of a close relationship between the variables
under discussion and sets the scene for the econometric analysis which
follows.
The issue is particularly important insofar as the recession caused the
automatic fiscal stabilizers to raise the PSBR above its 'consistent' path
and forced the following choice on the authorities: either raise interest
rates (which was not desired and probably reduced output further by
appreciating the exchange rate), reduce the PSBR by offsetting the
fiscal stabilizers (which also depressed output further), or allow
'cyclical' overshooting of the monetary targets. The issue is not a
peculiarly British one. Large federal US deficits have rekindled
American concern about the interest rate consequences of both the size
and the method used to finance these deficits. In this case analysts who
believe that large deficits cause high interest rates claim that excessive
borrowing by the Federal Reserve kept market interest rates from
declining appreciably in the early 1980's when inflation and economic
activity were slowing down.
There are three basic routes through which the level of public sector
borrowing, the growth of the money supply and interest rates are
related. These are the transactions approach, the portfolio balance
approach and the expectations approach.
The Transactions Approach
In the standard closed-economy ISLM framework, an increase in tlie
Government deficit will expand the level of income and raise the
transactions demand for money balances. This will cause the rate of
interest on bonds to rise by an amount depending on the way in which
the deficit is financed and on the interest elasticities of investment
expenditure and the demand for money.' If the economy under
A money-financed deficit could result in lower bond interest rates. McCaleb and Sellon Jr.
(1980) provide a neat discussion.
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