The demand for base money and the sustainability of public debt

Valeriano F. Garcia

No 1774, Policy Research Working Paper Series from The World Bank

Abstract: Key (related) factors in an analysis of debt sustainability should include: the demand for base money (or high powered money); projected fiscal balance; the real interest rate; and the rate of income growth. The author emphasizes the demand for base money, a variable that has received scant attention in the literature of fiscal debt sustainability. Given a constant base multiplier, the demand for real base money goes hand-in-hand with the demand for money. In fact, if we adjust the stock of money for changes in the base multiplier, shifts in the monetary base have to mirror changes in the money stock; and anything that changes the demand for money will also change the demand for base money. Consequently, a change in the expected cost of holding money, a change in permanent income, or an change in regime - which would no doubt affect the demand for real money- would also affect the real stock of base money. Naturally, base multipliers are not constant and more research on the relative stability of base money in debt ridden countries is warranted. Real interest rates are also important. Many Latin American countries have issued domestic bonds to sterilize the effect of capital inflows on the real exchange rate and, consequently, have significantly increased their real interest rate burden affecting their debt sustainability. Permanently increasing the fiscal surplus would improve debt sustainability if other variables remain unchanged. Furthermore, the author claims that a permanent increase in the fiscal primary surplus through expenditure reduction would have and important effect on debt sustainability because it would reduce real interest rates (less crowding out), increase income growth (allocation effect), and increase demand for monetary base (reduced inflation expectations and higher expected income growth).

Keywords: Environmental Economics&Policies; Economic Theory&Research; Payment Systems&Infrastructure; Banks&Banking Reform; Public Sector Economics&Finance; Economic Theory&Research; Environmental Economics&Policies; Banks&Banking Reform; Public Sector Economics&Finance; Strategic Debt Management (search for similar items in EconPapers)
Date: 1997-06-30
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