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Budget Deficits and the Money Supply

In the United States (and many other developed countries), the link between budget deficits and the money supply is complex. In the United States, if the Treasury spends more than it collects in tax revenue, it must finance the resulting deficit by borrowing funds from the public, which it does by selling U.S. government bonds. As you learned in Chapter 23, only the Federal Reserve can create money. The Fed is not part of the U.S. government. The fact that the government is operating with a deficit does not necessarily mean that the Fed will choose to increase the money supply. However, the Fed may very well be pressured to increase the money supply in response to a budget deficit. Whether this pressure will be effective depends on the strength and independence of the Fed chairman. Hence, there may sometimes be an indirect link between the U.S. budget deficit and money creation. The discussion question for this chapter is this: Should the Fed increase the money supply during this recession, what are some of the trade-offs that could be associated with this move, and what would be some possible consequences?