The Conduct of
Monetary Policy with a Shrinking Stock of Government Debt
By Stacey L. Schreft and Bruce D. Smith
October 2001
RWP 01-09
Research Division
Federal Reserve Bank of Kansas City
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 Window
JEL Codes: E4, E5, E6, H6
Stacey Schreft is is an assistant vice president and economist at the Federal Reserve Bank of Kansas City. Bruce D. Smith is a professor of economics at the University of Texas, Austin. The authors thank Craig Hakkio for inspiring this paper and Joe Lange and William Whitesell for providing relevant data. The views expressed in this paper are not necessarily those of the Federal Reserve Bank of Kansas City or the Federal Reserve System.
Schreft E-mail: stacey.l.schreft@kc.frb.org
Smith E-mail: bsmith@mundo.eco.utexas.edu