Deficits and the Demand for Money

In recent years, the large budget deficits of the Federal Government have renewed interest in the effects of government debt on private sector behavior. To date, empirical research has focused on the relationship between debt and two key variables, consumption and interest rates.' By contrast, empirical research on the effects of government debt on other variables of interest to macroeconomists is limited. This paper examines the relationship between government debt and one such variable, real money balances. The neglect of government debt as a determinant of money demand is surprising. Many traditional macroeconomic models, such as Blinder and Solow's [9] influential work, include government debt as an argument to the money demand function. Moreover, macroeconomic theorists have long been aware that a government debt - money demand relationship has important implications for the efficacy of fiscal policy.2 This paper examines the relationship between government debt and real money holdings over the 1950-1990 period. A positive money - debt relationship was previously noted by Butkiewicz [12] and Deravi, Hegji, and Moberly [15] (hereafter referred to as DHM). Our work improves upon this research in two ways. First, in contrast to Butkiewicz [12] and DHM [15], we investigate the time-series properties (stationarity, cointegration) of relevant variables. Second, we distinguish between supply-side and demand-side explanations of the debt-money relationship. The explanation advanced by Butkiewicz [12] and DHM [15] is that an increase government debt is perceived by the private sector as an increase in net wealth and hence should increase money demand.3 This explanation ignores a potentially important connection between government debt and money supply. If the Federal Reserve monetizes debt, and if the private sector's adjustment to this monetization is lagged, then debt and real money balances will exhibit a positive correla