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J JOURNALOF ECONOMICISSUES
Vol. XXIV No. 3 September2000
StephanieBell
The "Reserve
Effects"of Taxingand Spending
603
604 StephanieBell
ginning with the Federal Reserve's balance sheet, equivalentterms can be added to
each side, and the entries can be manipulatedalgebraicallyin order to isolate mem-
ber bank reserves.3 The result, often referredto as the "reserveequation,"depicts
total member bank reserves as the difference between alternativesources and uses
of reserve funds. The reserve equationcan be writtenas seen in Figure 1.
From Figure 1, it is clear that an increase in any of the bracketedterms on the
left will increase reserves, while an increase in any of the bracketedterms on the
right will reduce them.
Sources Uses
L
1~
000
~~~~~~... .ExpendituresSeii
L---Series2
K
4000 ~eceipts .. eis
u- 2000-
0 0
0 3/5 3/9 3/10 3/11 3/13 3/16 3/17 3/18 3/19 3/20 3/23 3/25 3/26 3/27 3/30
IL
Source:DailyTreasuryStatement,
http://fedbbs.access.gop.gov/dailys.htm
606 StephanieBell
FederalReserve
Other Account(Direct)
2% 13%
RemittanceOption
Depositaries
18%
Taxand LoanNote
Accounts
67%
Source:DailyTreasuryStatement,http://fedbbs.access.gop.gov/dailys.htm
? 20,000-
0
o w N O t CD a c
Source:DailyTreasuryStatement,
http://fedbbs.access.gop.gov/dailys.htm
transferredto the Treasury's account at the Fed (today) so that there would be no
net change in the level of reserves.
The Treasury transfersfunds to cover anticipatedshortfallsby making a "call"
on tax and loan accounts. In most cases, advancenotice is given before transferring
funds from these accounts.11A "reverse-call"or "directinvestment"is also possi-
ble. This would be necessary if the Treasuqr'sclosing balanceat Reserve banks was
expected to substantiallyexceed $5 billion. To avoid the reserve drain that would
result from an excessive closing balance, the Treasurymay place some or all of the
excessive funds into tax and loan accounts at Special Depositories (a.k.a. note-op-
tion banks). Whether"calling"fundsfom tax and loan accountsto make up for an
expected shortfall or transferringfunds to tax and loan accounts throughdirect in-
vestment (or canceling previous calls) to prevent an excessive closing balance, the
amounts transferredare intended to maintain the Treasury's balance at Reserve
banks as steady as possible. In pursuitof this goal, the Treasuryrelies on the coop-
erationof the Federal Reserve.
Treasury's ability to hit its target closing balance. Daily contact between the Treas-
ury and the Fed provide the Treasurywith "numerousoccasions . . . to assist the
Reserve authoritiesto achieve a desired objective"[Auerbach1963, 328].
Unfortunately,the Treasuryis unable, even with the cooperationof the Federal
Reserve, to completely offset the effects of its daily spending using tax and loan
calls and direct investment. Indeed, as Table 1 shows, the Treasury's average
monthlyclosing balance can differ substantiallyfrom its $5 billion target.
This, again, is the result of the inherentuncertaintyregardingthe size/timing of
receipts and expenditures.While it is easy to see how this uncertaintywould prevent
daily inflows and outflows from offsetting one another,Table 1 shows that even on
an average monthly basis, the Treasury's balance can close as much as 31 percent
above its target level. Thus, as Figure 5 confirms, one expects a non-zerochange in
the Treasury's daily closing balance. Despite this, changes in the daily closing bal-
ance do tend to fluctuate fairly closely aroundzero, deviating most drasticallywith
10,000
= 8,000
> 6,000
4,000
2,000
O__ 0A A-
-2,000
~)-4,000
Z -6,000
. -8,000
05 ' OC LO 0 t ( DC CY
Source: Daily Treasury
Statement,http://fedbb.acsgop.n co
Bondsto Coordinate
SeUling the Treasury'sOperations
ineligible for purchaseby tax and loan accountcredit and/or are not purchasedby a
so-called "note-option"bank (or one of its customers), the purchaseof government
bonds will immediatelydrain reserves from both the bank and the banking system.
This is because the proceeds from the sale of the securitieswill not stay "in the sys-
tem," but will be deposited directly into one of the Treasury'saccountsat a Federal
Reserve bank. When bonds are sold in this way, memberbank reserves decline as
the Federal Reserve credits the Treasury's account, increasing the right-hand
bracketin Figure 1. Thus, a bank wishing to purchaseU.S. governmentsecurities,
when tax and loan credit is not an option, will do so by drawing on its account at
the Federal Reserve. A system-wide loss of reserves will, therefore, accompany
every private purchase of newly issued government debt not eligible for payment
throughtax and loan credit.
Finally, the sale of Treasury securities to the Federal Reserve must be consid-
ered. If the Fed purchasesnewly issued bonds directly from the Treasury,it will not
cause a change in memberbank reserves. This, as Figure 1 makes clear, is because
both the right-hand bracket (U.S. Treasury Balance at Fed ) and the left-hand
bracket (U.S. GovernmentSecurities ) increase by the same amount, leaving total
reserves unaffected. Furthermore,since the government'sbalance sheet can be con-
sidered on a consolidatedbasis, given by the sum of the Treasury'sand Federal Re-
serve's balance sheets with offsetting assets and liabilities simply canceling one
anotherout [Tobin 1998], the sale of bonds by the Treasuryto the Fed is simply an
internal accounting operation, which provides the government with a self-con-
structedspendablebalance. Although self-imposedinstitutionalconstraintsmay pre-
vent the Treasuryfrom creatingall of its deposits in this way, there is no financial
constraintto prevent it from doing so. 15
Now, the Treasuryclearly has choices regardingthe mannerin which newly is-
sued bonds will be sold. For example, if the governmentplans to engage in deficit
spending, the Treasury can sell bonds, allow them to be purchasedby tax and loan
credit, and thereby eliminate any immediateimpact on reserves.16 When the Treas-
ury sells bonds in this way, the bonds act as a sort of ex ante coordinationtool.
Since the Treasurycan control the size and timing of funds transferredfrom tax and
loan accounts, this type of bond sale helps the Treasuryto drain (more or less) the
same numberof reserves from the system that are being addedto the system as a re-
sult of its deficit spending.17
If, however, there is a problemwith the coordination(for example, if the Treas-
ury and Fed underestimatethe amount of checks that are drawn on the Treasury's
accountat the Fed), bonds could be sold in orderto drainexcess reserves.18In other
words, insufficient tax and loan calls (which result in a system-wide increase in re-
serves and threatento send the overnight lending rate to a zero percent bid) could
prompt the sale of bonds as an ex post coordinationtool. In order to immediately
Do Taxesand Bonds Finance GovernmentSpending? 613
drain the excess reserves, banks could not be allowed to purchase the bonds by
creditinga tax and loan account, but this is somethingthe Treasurycan specify.
The purpose of this section is twofold. First, the commonly held belief that the
purpose of collecting taxes and selling bonds is to provide the governmentwith the
financialresources that fund its expenditureswill be examined. The questionwill be
addressed intuitively,drawingon the reserve effects analyzed in the first three sec-
tions of the paper. Second, for those who remainunconvincedby the intuitiveanaly-
sis, the question as to whether the proceeds from taxes and bond sales are even
capable of financing government spending will be considered. The argument re-
quires an application of basic accounting principles to an analysis of reserve ac-
counting in order to determine whether it is possible to use the revenues from
taxationand the sale of bonds to finance the government'sspending.
There is surely no doubt that the proceeds from taxationand bond sales are de-
posited into accountsheld by the U.S. Treasury(eitherwith commercialbanks or at
the Federal Reserve) and that the governmentspendsby writing checks on Treasury
accounts at Reserve banks. Moreover, since funds are transferredfrom tax and loan
accounts to the Treasury'saccountat the Fed in order to cover anticipatedshortfalls
in these accounts, it certainly looks as though the purpose of taxing and selling
bonds is to fund expenditures.This coordinationundoubtedlysupportsthe belief that
taxes and bond sales are necessary sources of governmentrevenue. But the coordi-
nation of taxationand bond sales with (deficit) spendingis actuallya somewhat dif-
ferent operation.
An intuitive analysis of Treasuryoperationssuggests a practical motivation for
the coordinationof taxationand bond sales with governmentspending. Specifically,
because of the reserve effects of taxing, spending, and selling bonds, the govern-
ment chooses to coordinate these operations in order to mitigate the impact on
banks' reserve positions and, hence, on short-terminterest rates. This interdepend-
ence, then, is not defacto evidence of a financingrole for taxes and bonds.
Similarly, the governmentneed not borrow from the private sector by issuing
bonds in order to enable it to spend in excess of currenttaxation.This, again, is be-
cause the governmentcan always create its own spendablebalance internally(on its
consolidatedbalance sheet) by offsetting a Treasuryliability against a Federal Re-
serve asset (e.g., but not necessarily, a Treasurybond). In the absence of private
bond sales, deficit spending would result in a net increase in aggregate bank re-
serves. Bonds, then, are used to coordinatedeficit spending, draining what would
otherwise become excess reserves. Govermnent debt provides the private sector
with an interest-earningalternativeto non-interest-bearinggovernmentcurrency, al-
lowing the governmentto spend in excess of taxationwithout driving the overnight
614 StephanieBell
lending rate down. Thus, taxes can be viewed as a means of creatingand maintain-
ing a demand for the government'smoney, while bonds, which are used to prevent
deficit spending from flooding the system with excess reserves, are a tool that al-
lows positive overnight lending rates to be maintained.Their coordination,it is ar-
gued here, is undertakenfor pragmaticratherthan "financial"reasons.
There is a danger that this argumentmay be viewed as pure semantics. This is
not so. That is, while it is certainlyappropriateto consider taxationand bond sales
as part of the process of governmentfinance, the implicit treatmentof money, in its
physical form, being transferredfrom the private to the public sector results in a
misleading treatmentof taxes and bond sales as necessary sources of government
revenue. In a world where money has been effectively divorced from commodities,
and where public and private sectors can vary the amountof money to be spent, this
naive way of thinkingcan be highly deceptive.
That such a treatmentcould have gone uncontestedfor so long is, perhaps, sur-
prising. Indeed, some readersmay resist acceptingthe claims made in this paper on
the grounds that they would, were they correct, have been made long ago. But there
have been a number of earlier critics who, although they did not undertakea de-
tailed analysis of the institutionalworkings of governmentfinance, reached similar
conclusions. Abba Lerner, for example, argued that "taxingis never to be under-
taken merely because the governmentneeds to make money payments"[1943, 40].
He furtherrecognized that the governmentshould sell bonds "only if it is desirable
that the public should have less money and more governmentbonds, for these are
the effects of governmentborrowing,"adding that "thismight be desirableif other-
wise the rate of interest would be reduced too low" [1943, 40]. Thus, the main
points made in this paper were made long ago, but they did not succeed in over-
throwingexisting theories regardingthe natureof governmentfinance.
Perhaps this was because Lerner, who attemptedto persuadehis opponentson
logical grounds alone, providedno evidence to supporthis claims. A more compel-
ling case can be made, it is arguedhere, throughan applicationof simple account-
ing. The argument is a technical one and requires an understandingthat Federal
Reserve notes (and reserves) are booked as liabilities on the Fed's balance sheet and
that these liabilities are extinguished/dischargedwhen they are offered in paymentto
the state. It must also be recognized that when currency or reserves returnto the
state, the liabilities of the state are reduced,and high-poweredmoney is destroyed.
The destructionof these promises is no differentfrom the private destructionof
a promise once it has been fulfilled. In otherwords, when a bankmakes a loan to an
individual, it results in a promise to the bank. Once the promise is kept (i.e., the
loan is repaid), the loan debt is eliminatedfrom the borrower'sbalance sheet. Like-
wise, the state, once it fulfills its promise to accept its own money (high-powered
money) at state pay-offices, eliminatesan equivalentnumberof these liabilities from
its balance sheet.
Do Taxes and Bonds Finance GovernmentSpending? 615
Thus, while bank money (MI) is destroyed when demanddeposits are used to
pay taxes, the government'smoney, high-poweredmoney, is destroyedas the funds
are placed into the Treasury's account at the Fed. Viewed this way, it can be con-
vincingly arguedthat the moneycollected from taxationand bond sales cannotpossi-
bly finance the government'sspending. This is because in order to get its hands on
the proceeds from taxationand bond sales, the governmentmust destroy what it has
collected. Clearly, governmentspending cannot be financed by money that is de-
stroyed when received in paymentto the state.
How, if not by using the money received in payment of taxes and bond sales,
does the governmentfinance its spending?Notice that the governmentwrites checks
on an account that does not comprise part of the money supply or high-powered
money, but that when it does, the fundsbecome partof the money supply (Ml if de-
posited into checking accounts, M2 if into savings accounts, etc.) and part of the
monetarybase. It is therefore apparentthat while the paymentof taxes destroys an
equivalentamountof money (MI immediatelyand high-poweredmoney as the pro-
ceeds go into the Treasury'saccountat the Fed), spendingfrom this accountcreates
an equivalent amount of new money-both bank money and high-poweredmoney.
In short, the governmentfinances all of its spending throughthe direct creation of
new (high-powered)money.
Summaryand Conclusions
Fiscal policy has more, and monetarypolicy less, to do with the money supply than
is usually recognized. An analysis of reserve accountingreveals that all government
spending is financedby the direct creation of high-poweredmoney; bond sales and
taxationare merely alternativemeans by which to drain reserves/destroyhigh-pow-
ered money. The debate over alternative "financing"methods, then, should really
be a debate over the alternativemethodsfor drainingreserves (taxes vs. bond sales)
in order to prevent the overnight lending rate from falling to zero. As Lerner ar-
gued, it is not so-called "sound"but "functional"finance that moderngovernments
should practice, and this means using taxes and bonds "simplyas instruments,and
not as magic charms that will cause mysterioushurt if they are manipulatedby the
wrong people or withoutdue reverencefor tradition"[1943, 51].
Notes
1. Early debates [Modigliani 1961; Blinderand Solow 1973, 1976; Barro 1974; Buiter 1977;
Lerner 1973; Tobin 1961] over the optimal method by which to finance deficit spending
remain a controversial topic today [Trostel 1993; Ludvigson 1996; Smith and Villamil
1998]. Despite differing beliefs about the macroeconomicconsequences of, say, borrow-
ing vs. "printingmoney," economists on both sides of these debatesclearly accept that the
purpose of collecting taxes and selling bonds is to secure funds that are then respent by the
government. In other words, it is generally agreed that the role of taxationand bond sales
is to transfer financial resources from households and businesses (as if transferringactual
dollar bills or coins) to the government, where they are respent (i.e., in some real sense
"used"to finance government spending). This erroneous view follows from an implicit
treatmentof money in its physical form and can be avoided by considering the balance
sheet and reserve effects of taxationand bond sales. This, in short, is the purpose of this
paper.
2. Although reserve requirementsare generally met by holding a combinationof vault cash
and checking accountsat districtFederalReserve banks, accountsheld by depositoryinsti-
tutions at Federal Home Loan Banks, the National Credit Union AdministrationCentral
LiquidityFacility, or correspondentbanks may also count toward satisfyingthe reserve re-
quirement. Depository institutionsdo not have to meet these reserve requirementson a
daily basis. They have a two-week "reserveperiod"(endingon Wednesdays)within which
they must maintainaverage daily total reserves equalto the requiredpercentage of average
daily transactionsaccounts held during the two-week period ending the preceding Mon-
day. Thus, despite being referredto as a contemporaneousreserve accounting(CRA) sys-
tem, it is, in practice, lagged for two days. That is, banksalways have two days (Tuesday
and Wednesday)within which to acquire (ex post) reserves needed to eliminate a known
deficiency. While some banks may choose to hold excess reserves, profit-maximizing
banks will economize on reserves. Unless a bank has a preference for idle funds, it will
exchange excess reserves for "earningassets" such as loans or securities.
3. See Ranlett [1977, 191-1931for the derivation.
4. It is, of course, true that the Treasury keeps accounts at thousandsof commercial banks
and other depository institutionsas well as Federal Reserve banks. This changes things
considerablyand will be takenup in the next section.
5. It is worth noting that governmentspending must originally have preceded taxation. That
is, the payment of taxes could not increase the Treasury's account at the Fed (Figure 1,
right-handbracket), reducing bank reserves, until the reserves had been created. More-
618 StephanieBell
over, the Federal Reserve and/or Treasury, as the only agents capable of supplyingthem,
must have been the original source of these reserves. This will be taken up in the section
titled TheNuances of ReserveAccounting.
6. When there is a reserve deficiency for the bankingsystem as a whole, banks could attempt
to resolve the deficiency by reducingdeposits. If a single bank begins this process (selling
U.S. securities to a member of the non-bankpublic or allowing loans to be repaidwithout
reissuing them), it will result in a multiplecontractionof deposits (assumingall banks fol-
low suit). Though this would ultimatelyeliminatethe banking system's reserve deficiency
(without requiringbanks to acquire additionalreserves), the process takes time and will
disruptinterest rates until "equilibrium"is restored. Deficiencies thereforewill usually be
eliminatedas the bankingsystem acquiresmore reserves, not as it reduces depositsthat re-
serves are requiredto "backup."
7. The IndependentTreasury System was in effect long before the establishmentof the Fed-
eral Reserve System. It was established in 1840, abolished the following year, re-estab-
lished in 1846, and discontinuedin 1921.
8. General Depositories have become known as "remittance-option banks,"while Special De-
positories are currentlyreferredto as 'note-optionbanks."Both are depositoryinstitutions
with tax and loan accounts, but a "remittance-option bank," like its predecessor, the Gen-
eral Depository, must remit its tax and loan accountbalancesto a Reserve bankthe day af-
ter the funds are received. In 1978, note-option banks were given the opportunityto
accumulatethe daily tax paymentsthey receive by transferringthem from the ordinarytax
and loan accounts (where they are held interest-freefor one day) into an interest-bearing
"noteaccount." Up to a pre-approvedlimit, these funds can remainin "noteaccounts"un-
til the Treasury "calls"for them to be transferredto Reserve Banks [Manypennyand Ber-
mudez 1992, 728].
9. In this case, a distinctionbetween the "supplyof money" and high-poweredmoney (bank
reserves and currency outstanding)should be made. When tax receipts are placed into a
tax and loan account, high-poweredmoney is not affected. The narrowmoney (MI), how-
ever, is. When funds are transferredfrom demand deposits, where they are part of M1,
into tax and loan accounts (or the Treasury's accountat the Fed), which is not part of any
standardmeasureof the money supply (MI, M2, etc.), the "moneysupply"declines.
10. This is not because the government needs the proceeds from taxation in order to spend
again, but because it chooses to coordinateits taxing and spending. This will be taken up
in the final section.
11. Special Depositories (or note-optionbanks) fall into three categories: A banks, B banks
and C banks. A and B banks are typically smaller institutions,while depositoriesthat are
classified as C banks are generally large banks. Tax and loan calls are calculatedas frac-
tions of the book balance in each tax and loan account on the previous day. "Calls"made
on A and B banks are usually made with longer lead times than calls made on C banks,
and the latter are usually the only banks against which same-dayor next-day calls may be
issued.
12. The closing balance in the Treasury's account at the Fed could exceed the target level for
two reasons. First, previously placed tax and loan calls may have been too large. In this
case, the amount of spending from accounts at Reserve banks is less than the sum of the
paymentsreceived directly into accountsat the Fed and the amounts "called"from tax and
loan accounts. Second, it is possible that the paymentsmade to the governmentand depos-
ited directly into accounts at Reserve banks exceed the amount presented for payment
from these accounts. This could happen, for example, during months in which quarterly
tax payments sent directly to accounts at the Fed are large enough to more than compen-
sate for governmentspending.
13. The Treasurywill not, in all instances, be successful in its attemptto directly invest its ex-
cess funds. Some note-optionbanks will not meet the collateral requirementsand will be
Do Taxes and Bonds Finance GovernmentSpending? 619
ineligible recipients of additionaltax and loan funds. Additionally,tax and loan accounts,
like the Treasury's account at the Fed, may swell during unusually heavy quarterlytax
payments. Because banks must pay intereston tax and loan accounts, they limit the size of
the tax and loan balances they are willing to accept. When direct investmentis not an op-
tion, the Treasury can attemptto cancel previously scheduledcalls in an attemptto draw
down its balance in Reserve banks.
14. The reader might wonder whetheradditionalreserves are requiredas a result of the larger
tax and loan balance. The answer is no. Since the establishmentof interest-bearingnote
accounts in November 1978, Special Depositories have been free of reserve requirements
againsttax and loan deposits.
15. The Federal Reserve was, for a time, prohibitedfrom purchasingbonds directly from the
Treasury. This changed during World War II, when the Fed was authorizedto purchase
up to $5 billion of securities directly from the Treasury. Since then, the limit has been
raised several times.
16. Boulding [1966] notes that deficit spendingmost commonly involves this practice.
17. Note that the government can deficit spend without taxing or selling bonds first, but if
government spending is greater than taxation, the bankingsystem will be left with excess
reserves. The Treasury, therefore, prefers to use bonds to coordinateits deficit spending,
selling them to Special Depositories (and allowing tax and loan credit) before spending
from its accounts at Reserve banks. The bonds, then, allow the governmentto defend (ex
ante) the fed funds rate.
18. Note that bonds would have to be sold even if the governmentran an annually balanced
budget. This is because it is impossibleto eliminatethe "reserveeffects" of the Treasury's
daily operations. Thus, swings in the Treasury's daily closing balance, which threatento
move the funds rate away from its target, would induce the sale of bonds despite an annu-
ally balancedbudget.
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