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When I was in graduate school in the olden days (1960s), Professor Waller hired me as his grader in his money and banking and monetary policy classes. At first, he limited my chores to multiple-choice and true-false questions, but he gradually trusted me with essay questions--following his strict guidelines of course.

"Are budget deficits inflationary?" was one of his favorite questions on final exams, and he had a precise idea of the components of an "A" answer. Using T-Accounts (Remember the Chicago Fed's Modern Money Mechanics booklet?), the students were supposed to show the alternate ways of financing government spending, including deficits. The answer to the question, you see, depended almost entirely on the method of financing. Another way of saying that is that the impact of fiscal policy depended almost entirely on the accompanying monetary policy.

I'll spare you the T-Accounts and just summarize the conclusions: Government spending financed by taxes was not inflationary (or even expansionary) because the government's new spending was offset by a reduction in private spending. There would be little or no net change in total spending. That did not mean the alternatives of government versus private spending had no other consequences. Professor Waller greatly preferred people spending their own money rather than having the government doing it for them.

Government spending financed by bond sales to private individuals and companies had expansionary/inflationary consequences very similar to a balanced budget. The money the government got to spend was money the bond purchasers no longer had to spend. There was no net change in bank deposits, bank reserves, or the money supply.

Government spending financed by bond sales to commercial banks did increase bank deposits and the money supply and was presumably more expansionary. Commercial banks, however, used up excess reserves in buying the bonds that might have been used making other investments or loans. With the extreme assumption of no excess reserves prior to the deficit financing, the expansion of bank deposits and the money supply would likely be no greater than what would have happened anyway. The expansion in bank deposits that took place was a one-shot deal rather than the beginning of a multiple expansion process since bank reserves were not increased. So, financing government spending with bond sales to the banking system (under normal times with little or no excess reserves) may have been a little expansionary, but no more than would have likely happened anyway.

Government spending financed by bond sales (indirectly) to the Federal Reserve by having the Fed buying bonds in the open market at about the same time as the Treasury was issuing new debt was the most expansionary/inflationary financing method of all. That's because bank deposits initially increase by the amount of the Fed's purchases, but so do bank reserves. The reserve expansion creates sufficient excess reserves to permit the banking system to continue making loans and investments and creating deposit money in the process until the total money created reached a multiple of the purchases-that multiple being the inverse of the required reserve ratio.

In other words, if the Fed buys $10 million (in those days) of Treasury bills and the average marginal reserve requirement of banks was 10 percent, the total deposit expansion of the banking system could be $100 billion.

The previous example amounts, figuratively, to printing money. The Treasury has new money to spend that was not given up by the private sector. Everybody else still has the money they had and the Treasury has more. This is the most expansionary/inflationary method of finance of all. Note that I had the Fed buying the Treasury debt "indirectly" in the open market rather than directly from the Treasury because it is a process easy to abuse. The law restricts such direct purchases. Think "monetary incest."

Professor Waller insisted that an "A" answer to the question had to contain the essence of the above, but it must also contain the following point: Whether the method of financing government spending was expansionary or inflationary depends largely on the state of the economy. The closer the economy is to full employment of labor and other resources, the more likely the new spending with newly created money would cause inflation. An economy in a deep recession with high unemployment of labor and low capacity utilization might be able to produce more goods and services as a result of the new spending. To that extent it would be expansionary, not inflationary, or not as inflationary as it otherwise would be.

It seems to me that contemporary talking heads would do well to review some of these fundamental principles and include some of the important qualifications and caveats into their thinking. We rarely hear of the important role of the financing when we hear of the inflationary consequences of budget deficits. Professor Waller, we need you.

Source: Are Budget Deficits Inflationary?