The Conduct of Monetary Policy with a Shrinking Stock of Government Debt

FRB of Kansas City Research Working Paper No. 01-09

45 Pages Posted: 17 Dec 2001

See all articles by Stacey Schreft

Stacey Schreft

Government of the United States of America - Office of Financial Research; Board of Governors of the Federal Reserve System

Bruce D. Smith

University of Texas at Austin (Deceased)

Date Written: October 2001

Abstract

In many countries, government-budget surpluses have led to a decline in the amount of federal government debt outstanding. This paper considers the consequences of this development for a central bank that conducts monetary policy through open market operations in treasury debt. A model is presented in which a treasury taxes, spends, and issues debt; a central bank conducts monetary policy through open market operations; and banks are intermediaries for all private savings. The model suggests potentially severe consequences from a shrinking stock of government debt in the absence of a change in the conduct of monetary policy. Specifically, the nominal interest rate and the inflation rate cannot be below their seigniorage-maximizing levels. In effect, a small stock of debt combined with restrictions on a central bank's portfolio can put the economy on the Pareto inferior side of the seigniorage Laffer curve, with an unnecessarily high inflation rate and nominal interest rate. Moreover, if the government also runs a primary budget deficit, equilibrium can fail to exist. The model presented can yield estimates of how much debt must be outstanding to avoid each situation. Discount-window lending is a feasible - and desirable - alternative method for conducting monetary policy. It relaxes any restrictions on the attainable set of interest rates and inflation rates implied by a decline in the stock of government debt outstanding. Unless the economy is on the Pareto inferior side of the Laffer curve, welfare is higher when discount-window loans are made at market-determined interest rates.

Keywords: Monetary Policy, Fiscal Policy, Government Debt, Discount

JEL Classification: E4, E5, E6, H6

Suggested Citation

Schreft, Stacey L. and Smith, Bruce D., The Conduct of Monetary Policy with a Shrinking Stock of Government Debt (October 2001). FRB of Kansas City Research Working Paper No. 01-09, Available at SSRN: https://ssrn.com/abstract=294107 or http://dx.doi.org/10.2139/ssrn.294107

Stacey L. Schreft (Contact Author)

Government of the United States of America - Office of Financial Research ( email )

717 14th Street, NW
Washington DC, DC 20005
United States

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Bruce D. Smith

University of Texas at Austin (Deceased)