What Does It Mean When “The Monetary Authority Is Financing the Fiscal Authority”?

The fiscal authority is Congress (along with the president), which passes budgets regarding federal taxation and expenditures. In economics, these types of actions are called fiscal policy, which means Congress is the fiscal authority. Tax cuts and increased spending can stimulate an economy to fight unemployment, and the opposite actions can cool it down to fight inflation.

The Federal Reserve (the Fed) effectively sets the federal funds rate, a short-term interest rate at which banks loan to each other, and uses this to also stimulate or cool down the economy with lower or higher interest rates, respectively. This is called monetary policy, which means the Fed is the monetary authority.

I say “effectively sets” because it doesn’t dictate the interest rate but influences it until it reaches a targeted level. This next bit requires a bit of explanation. For any bond (debt instrument), if the issuer offers a higher interest rate (or coupon), it is more attractive to investors, but this is more costly to the issuer. If more investors want to buy the bond, then the issuer can lower the coupon and still sell the bond.

Now, the means by which the Fed “effectively sets” the federal funds rate is via buying and selling of U.S. Treasuries on the open market. When it buys Treasuries, this increases the demand for Treasuries, thus reducing the coupon the U.S. Government needs to offer. This both reduces interest rates and increases the amount of money in circulation by the dollars the Fed uses to buy the Treasuries. Thus, it increases the money supply. Conversely, when it sells Treasuries, the dollars come into the Fed and out of circulation, reducing the money supply.

Lastly, increasing the money supply can lead to the dollar being worth less, which can reduce the value of debt people have. When the fiscal authority (Congress and the president) runs federal deficits leading to a federal debt, and the monetary authority (the Fed) increases the money supply to inflate away the debt, this is caused monetizing the debt. Essentially, this quote is highlighting the conflict of interest that exists when the government can both run a debt and monetize that debt. And it also oddly results in one part of the government issuing debt instruments being purchased by another part of the government.

Originally posted at Quora

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