The Short Run Impact of Fiscal Policy on the Money Supply

The absence of stronger empirical support for a positive fiscal policy-money supply relationship seems surprising in view of the frequently heard argument, often associated with the monetarists, that large fiscal deficits typically result in substantial increases in the monetary aggregates. Actually, the problem is even more complex since the effect of fiscal policy on the monetary policy variable represents only one channel by which fiscal policy can affect the money supply. That is, fiscal policy, by changing such variables as income and interest rates, affects private sector behavior, which in turn affects the money supply. For this reason, 2 cases are considered: one in which the Federal Reserve is considered exogenous and the second in which the Federal Reserve is made endogenous. A linear variant of the IS-LM model is estimated that incorporates endogenous taxes, a wealth variable, and inflationary expectations. The narrow definition of the money supply is utilized. Unborrowed reserves are used as the monetary policy variable. The empirical results support the contention that unborrowed reserves are endogenous.