ABSTRACT
The objective of this chapter is to examine the effects of deficits on money supply. This involves two steps. The first, as seen in the previous chapter, is the relationship between the monetary base or high-powered money and the budget deficit, and the second is the relationship between money supply and the monetary base. A rigorous approach to the question under discussion would be to specify the determinants of the monetary base, as in Chapter 3, and then the determinants of the relationship between money supply and the monetary base. This latter, as we know, requires the speficiation of the determinants of money multipliers. Since the money multiplies, depending on the definition of money supply used, consist of the ratio of currency to demand deposits and that of bank reserves to demand deposits in the case of M1, for example, it follows that the determinants of the multiplier implies specifying the determinants of these ratios. Since these ratios are the outcome of the portfolio behaviour of the non-bank public and the banks, we need to specify models determining such behaviour. Once we have done that, we can combine the analysis of the previous chapter and these models, and examine the relationship between budget deficits and money supply. This is a huge task beyond the scope of this study. Our approach, instead, is to estimate alternate reduced-form equations detailing the relationship between money supply and budget deficits. This is also the approach which has been commonly used in the literature.1
