Understanding fiscal and monetary policy by looking at government liabilities

By “ government ” , we refer to the government itself and the central bank as a consolidated whole , since the central bank is an organ of government and pays its profits to it . The liabilities of the government thus defined contain : Bonds (the portion of the public bond debt that is not held by the central bank); Banknotes; Treasury bills (short-term government debt); Bank reserves at the central bank. The quantity of banknotes depends on demand for banknotes. If a higher fiscal deficit is run, it will be financed either by issuing bonds or treasury bills, or by increasing banks’ reserves at the central bank. If the central bank practises quantitative easing, bonds are transformed into bank reserves; if the central bank “twists” the yield curve, bonds are transformed into treasury bills. This raises several questions: How substitutable are bonds, treasury bills and bank reserves? If these three financial assets are highly substitutable, the composition of the government’s liabilities, how the fiscal deficit is financed and quantitative easing are inconsequential. We believe bonds are only slightly substitutable for the other two assets: the monetisation of fiscal deficits therefore has consequences; What is the limit to the issuance of these different assets, i.e. what is the limit to public borrowing ? Is a large increase in the government’s bond liabilities more dangerous (risk of a debt crisis) than a large increase in its money market liabilities (treasury bills and bank reserves), given the risk of financial instability? Central banks evidently think that an increase in the government’s bond liabilities is more dangerous.