The Demand for Base Money and the Sustainability of Public Debt

Anything policy makers can do to increase the demand for base money will help solve public debt problems. Key (related) factors in an analysis of debt sustainability should include:

• The demand for base money (or highpowered money).

• Projected fiscal balance.

• The real interest rate.

• The rate of income growth.

Garcia emphasizes the demand for base money, a variable that has received scant attention in the literature of fiscal debt sustainability.

Given a constant base multiplier, the demand for real base money goes hand in hand with the demand for money. In fact, if we adjust the stock of money for changes in the base multiplier, shifts in the monetary base have to mirror changes in the money stock; and anything that changes the demand for money will also change the demand for base money.

Consequently, a change in the expected cost of holding money, a change in permanent income, or a change in regime-which would no doubt affect the demand for real money-would also affect the real stock of base money. Naturally, base multipliers are not constant and more research on the relative stability of base money in debt ridden countries is warranted.

Real interest rates are also important. Many Latin American countries have issued domestic bonds to sterilize the effect of capital inflows on the real exchange rate and, consequently, have significantly increased their real interest rate burden affecting their debt sustainability.

Permanently increasing the fiscal surplus would improve debt sustainability if other variables remain unchanged. Furthermore, Garcia claims that a permanent increase in the fiscal primary surplus through expenditure reduction would have an important effect on debt sustainability because it would reduce real interest rates (less crowding out), increase income growth (allocation effect), and increase demand for monetary base (reduced inflation expectations and higher expected income growth).

This paper - a product of the Economic Adviser's Unit, Latin America and the Caribbean, Office of the Regional Vice President - is part of a larger effort in the region to address debt and fiscal issues. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Jorge Forgues, room I8449, telephone 2024739774, fax 2026769271, Internet address jforgues@worldbank.org. June 1997. (36 pages)

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