The Short Run Impact of Fiscal Policy on the Money Supply

Abstract

Surprisingly little research effort has been devoted to the study of the impact of fiscal variables on the money supply. Furthermore, the limited amount of empirical evidence is often ambiguous and contradictory. Both Froyen [10] and Barro [1] find some evidence of a positive relationship between fiscal expansion and either the money supply or a monetary policy variable, implying that the monetary authorities tend to accommodate fiscal policy. Some evidence of a negative relationship is found in studies by Wood [27], Friedlaender [9], Gordon [13], and Cacy [3]. This implies that monetary actions tend to offset, rather than accommodate, expansionary fiscal actions. The absence of stronger empirical support for a positive fiscal policy-money supply relationship seems surprising in view of the frequently heard argument-often associated with the monetarists, as in Fand [6] and Buchanan and Wagner [2]-that large fiscal deficits typically result in substantial increases in the monetary aggregates. Exactly how this process is supposed to work is not always clear, but perhaps a typical explanation is outlined by Francis [8]. The Federal Reserve is seen as having an over-riding concern with stabilizing interest rates, so that fiscal expansion leads more or less mechanically to an increase in the money supply. An expansionary fiscal policy action results in aon budget deficit which must be financed through issuance of government securities; the sale of these securities to the private sector puts upward pressure on market interest rates; this upward pressure is countered by Federal Reserve purchases of outstanding government securities, thereby monetizing, at least in part, the debt issued to finance the deficit. But to consider interest rate stabilization-or financial market stability-as the single goal of the Federal Reserve would clearly be extreme. Previous studies which have estimated policy reaction functions for the Federal Reserve-including those of Wood [27], Friedlaen-