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Part 15. How governments borrow money

Governments borrow money by issuing bond certificates, which are then purchased by banks, other institutions and people. Bond certificates are effectively promissory notes from the government, promising to pay the money borrowed back at a specified date, usuallly with interest. So they are liabilities to the government that issues them and assets to those that purchase them.

Let's go back to our sets of accounts from the end of Part 12 again, and consider the issue of two £20,000 government bonds, one purchased by the house seller and the other by 2nd Bank. We will assume the government banks with 1st Bank and will add a new account called Government's Deposit Account to hold the funds from the bond issues. The house seller will keep their bond certificate outside of our sets of accounts, so it won't appear on our banks' balance sheets (it would appear on the house seller's balance sheet, should they produce one), whilst 2nd Bank will need a new asset account we will call Government Bonds.

Let's start with the house seller's bond purchase. This is shown in Figure 15.1

House Seller's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £90,000 (CR) Purchase of government bond £20,000 £70,000 (CR) Government's Deposit Account 1st Bank Description Debits Credits Balance Starting balance £0 Sale of government bond £20,000 £20,000 (CR)

Figure 15.1 Government bond purchase by the house seller.

We will carry out a deferred settlement double entry, as usual, for the bond purchase, as shown in Figure 15.2.

2nd Bank's Loan Account 1st Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £20,000 £20,000 (DR) 1st Bank's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £20,000 £20,000 (CR)

Figure 15.2 Deferred settlement for the bond purchase.

2nd Bank's bond purchase is shown in Figure 15.3.

Government Bonds 2nd Bank Description Debits Credits Balance Starting balance £0 Purchase of government bond £20,000 £20,000 (DR) Government's Deposit Account 1st Bank Description Debits Credits Balance Starting balance £0 Sale of government bond £20,000 £20,000 (CR) Sale of government bond £20,000 £40,000 (CR)

Figure 15.3 Government bond purchase by 2nd Bank.

As this is also a double entry across banks, we need to carry out a deferred settlement double entry again. This is shown in Figure 15.4.

2nd Bank's Loan Account 1st Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £20,000 £20,000 (DR) Borrowed by deferring settlement £20,000 £40,000 (DR) 1st Bank's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £20,000 £20,000 (CR) Owed by deferring settlement £20,000 £40,000 (CR)

Figure 15.4 deferred settlement for the second bond purchase.

The bank's balance sheets now look as shown in Figure 15.5, the blue arrow indicating, as before, the amount we need to settle between banks.

Central Bank's Assets Mortgage-backed Securities £50,000 Total assets £50,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £45,000 1st Bank's Digital Reserves £5,000 Total liabilities £50,000 1st Bank's Assets Mortgage Loan Account #1 £100,000 2nd Bank's Loan Account £40,000 Mortgage-backed Securities £50,000 Digital Reserves £5,000 Total assets £195,000 1st Bank's Liabilities Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Government's Deposit Account £40,000 Total liabilities £195,000 2nd Bank's Assets Equity Release Loan Account £50,000 Digital Reserves £45,000 Government Bonds £20,000 Total assets £115,000 2nd Bank's Liabilities House Seller's Deposit Account £70,000 1st Bank's Deposit Account £40,000 Deposit Account #4 £5,000 Total liabilities £115,000

Figure 15.5 Balance sheets after the bond purchases.

We will now settle between banks by transferring £40,000 of reserves from 2nd Bank to 1st Bank. First, we transfer £40,000 from 1st Bank's Deposit Account to 2nd Bank's Deposit Account as shown in Figure 15.6.

1st Bank's Deposit Account 2nd Bank Description Debits Credits Balance Previous balance £0 Owed by deferring settlement £20,000 £20,000 (CR) Owed by deferring settlement £20,000 £40,000 (CR) Transferred to 2nd Bank £40,000 £0 2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Received from 1st Bank £40,000 £40,000 (CR)

Figure 15.6 Transfer from 1st Bank Deposit Account to 2nd Bank Deposit Account.

Next we transfer reserves from 2nd Bank to 1st Bank. As before, we reduce 2nd Bank's reserves, as shown in Figure 15.7.

Digital Reserves 2nd Bank Description Debits Credits Balance Previous balance £45,000 (DR) Transfer reserves £40,000 £5,000 (DR) 2nd Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £45,000 (CR) Transfer reserves £40,000 £5,000 (CR)

Figure 15.7 Reduction of 2nd Bank's reserves.

Then, we increase 1st Bank's as shown in Figure 15.8.

1st Bank's Digital Reserves Central Bank Description Debits Credits Balance Previous balance £5,000 (CR) Transfer reserves £40,000 £45,000 (CR) Digital Reserves 1st Bank Description Debits Credits Balance Previous balance £5,000 (DR) Transfer reserves £40,000 £45,000 (DR)

Figure 15.8 Increase of 1st Bank's reserves.

Finally, we clear 2nd Bank's balances at 1st Bank by transferring £40,000 from 2nd Bank's Deposit Account to 2nd Bank's Loan Account as shown in Figure 15.9.

2nd Bank's Deposit Account 1st Bank Description Debits Credits Balance Previous balance £0 Received from 1st Bank £40,000 £40,000 (CR) Transferred to loan account £40,000 £0 2nd Bank's Loan Account 1st Bank Description Debits Credits Balance Previous balance £0 Borrowed by deferring settlement £20,000 £20,000 (DR) Borrowed by deferring settlement £20,000 £40,000 (DR) Received from loan account £40,000 £0

Figure 15.9 Transfer from 2nd Bank's Deposit Account to 2nd Bank's Loan Account to clear balances.

And the final balance sheets of all banks are shown in Figure 15.10.

Central Bank's Assets Mortgage-backed Securities £50,000 Total assets £50,000 Central Bank's Liabilities 2nd Bank's Digital Reserves £5,000 1st Bank's Digital Reserves £45,000 Total liabilities £50,000 1st Bank's Assets Mortgage Loan Account #1 £100,000 Mortgage-backed Securities £50,000 Digital Reserves £45,000 Total assets £195,000 1st Bank's Liabilities Deposit Account #2 £45,000 Mortgage Loan Account #1 Security £100,000 Deposit Account #3 £10,000 Government's Deposit Account £40,000 Total liabilities £195,000 2nd Bank's Assets Equity Release Loan Account £50,000 Digital Reserves £5,000 Government Bonds £20,000 Total assets £75,000 2nd Bank's Liabilities House Seller's Deposit Account £70,000 Deposit Account #4 £5,000 Total liabilities £75,000

Figure 15.10 Balance sheets after the government bond issues.

By issuing bonds, the government now has £40,000 in its deposit account with 1st Bank that it can spend just like any other person or business. The total held in deposits at 1st Bank has been increased by £40,000 compared to before the bonds were issued. However, deposits of 2nd Bank have been reduced by £20,000. In total, we have an extra £20,000 in deposits across banks.

So, we can see that when a bank purchases a government bond, this increases the money supply. If a retail investor purchases a government bond, this doesn't alter the money supply.

Like with all bonds, government borrowing does incur interest and does eventually have to be paid back. This is discussed next.

back to Part 14