Recap from part IV – Modern Monetary System

In the previous part we went through the operations of money creation by both central banks and private banks. We explained the role played by and looked into the details on the coordination between treasury and central bank.

Highlight of part V – Deficit Spending Argument

In this part we will address three arguments that commonly arise when dealing with deficit spending: Sustainability, Inflation and Exchange rate.


Sustainability of government deficit

The deficit of the public sector corresponds to the private sector net wealth hence households and families benefit from a government spending more than what it taxes.

But is a persistent deficit sustainable in the long run?

  • For the private sector → Unlikely
  • For the public sectro → Very likely

In order to anlyse the sustainability of deficit spending we refere to the model proposed by James Galbraith.

∆d = −s + d ∗ [(r − g )/(1 + g )]


d = starting debt to GDP ratio
s = primary surplus
r = real interest rate
g = real GDP growth rate

What the above formula tells us is that the growth of the debt/GDP ratio (∆d) is equals to the sum of the primary surplus (s) and the initial debt/GDP ratio (d) multiplied by a rate factor ([(r − g )/(1 + g )]).

The element that determines the sustainability is the rate factor:

  • if r > g → debt/GDP grows
  • if r < g → debt/GDP declines
  • if r = g → debt/GDP remain the same

What happens to the private deficit (households and firms)?

The private sector is a currency user hence subject to both budget constraints and solvency issues.
The debt ratio will eventually grow unsustainable and the system will collapse.

What happens to the public sector (government)?

The sovereign public sector is a currency issuer hence it faces neither budget nor solvency issues.
The persistent deficit leads to scenarios that will eventually lower the deficit itself:

  • Inflation
  • Austerity
  • Private wealth effect

it causes tax revenues to raise so that they grow faster than public spending, hence the deficits decreases.

it leads to an increase of tax revenues or a decrease of government spending, thus lowering the deficits.
This measure is often counter-productive since the worsening of the private sector balance might affect negatively the growth rate and instead increase the debt ratio.

The wealth effect:
the government spending, principal and interest payments, adds to the private sector income, the rising wealth induces households and firms to adjust their saving and spending flows.

The logical conclusion about sustainability

The interest rate is actually a policy variable.
The government (Central Bank) can just lower the interest rate it pays below the GDP growth rate and it’s done, sustainability achieved.
And keep in mind that, for a sovereign country, solvency is never an issue.
A sovereign government will never be forced to default on a interest (or principal) payment on its own debt, no matter how big this becomes.

Full employment

Full Employment should be the main target in any ”civilised” country.

A sovereign government that issues its own fiat currency has the maximum policy space, both fiscal and monetary policy. It can spend enough to steer the economy towards full employment (and price stability) and it can set the interest rate target where it wants.

Affordability and solvency are not an issue since spending occurs by crediting bank accounts with its own currency and it cannot run out of its own currency.

The government should act as an Employer of Last Resort.

Functional and Sound finance

Contrasting policy approaches:

  • Functional finance → target full employment
  • Sound finance → target inflation
Approaches to public finance

Functional finance

In the functional finance approach the main target of public policies is the employment; the government budget and the inflation are the main instruments used for achieving full employment.

Abba Lerner in its, “Functional Finance and the Federal Debt” (1943) stated the two principles of functional finance:

  • First: 
    If domestic income is too low, the government needs to increase its spending. Unemployment is a sufficient evidence of this condition, if the economy is operating below full employment the government is not spending enough (or it is taxing too much).
  • Second: 
    If domestic interest rate is too high, the government needs to provide more liquidity (money) through bank reserve in order to lower the interest rate.


Sound finance

The sound finance approach moves the public purpose from job stability (employment) to price stability (inflation). The main target of public policies became then the inflation rate; the unemployment is now one of the instruments used for achieving price stability.

This is the approach that have been dominating the mainstream economics since 70’s and it can be summarised in four principles:

  1. The government must run its finance like a household or a firm, hence its budget is constrained.
  2. Government spending is constrained by tax revenue and ability to borrow.
  3. Printing money is very bad (highly inflationary).
  4. Inflation becomes the main target at the expense of unemployment.

The superstition of the balanced budget ⇒ … scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires.



From the postwar period onward the trend of consumer prices has been positive. The lack of deflations can be imputed big governments, hence deficit spending.

Inflation is not really a problem for (full) sovereign governments.

Some inflation is instead a positive thing since it encourages investment (higher nominal returns) and makes it easier to service debts.

Deflation is worse than inflation!

Problems with inflation:

extremely high inflation can cause the value of the domestic currency to drop to 0, resulting in the population running towards other currencies.

Main sources of inflation:

  • Aggregate demand → Excessive demand (aggregate demand gets too high in relation to the aggregate supply)
  • Market power (unions and oligopolies)
  • Baumol disease

Deficit spending by the government doesn’t necessarily generate inflation.

Policy makers usually over-react to inflation by introducing austerity measures.
Austerity might be a right solution to inflation only when the economy operates beyond full employment (Lerner’s first principle).

Inflation should not be seen as a problem as long as the economy is operating below full employment.
There is basically no evidence of some negative effects from persistent inflation with rates below 40% per year.

Hyperinflation → inflation rate of 50% or more per month.

  • Brazil
  • Weimar Republic
  • Zimbabwe


References for Part V:

Forstarter, M., 1999. Full Employment and Economic Flexibility, Economic and Labour Relations Review, Volume 11.

Galbraith, James K. 2011. Is the Federal Unsustainable? Levy Economic Institute Policy Note 2011/2.

Mosler, W.and Forstater, M.(1999) A General Framework for the Analysis of Currencies and Commodites, in Davidson P. and J.A. Kregel (ed) Full Employment and Price Stability in a Global Economy, 166-177. Northampton: Edward Elgar Publishing, Inc, 1999.

Lerner, Abba (1943). Functional Finance and the Federal Debt. Social Research vol. 10, 38-51.

Wray, L.R. (1998) Understanding Modern Money: The Key to Full Employment and Price Stability. Northampton: Edward Elgar.