Governments borrow money by issuing bond certificates that are then purchased by banks, other institutions and people.
A bond is effectively a kind of promissory note from the government
pledging to pay the money borrowed back at a specified date, usually with interest.
Bonds 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 issuance 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
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.
Figure 15.2 Deferred settlement for the bond purchase.
2nd Bank's bond purchase is shown in Figure 15.3.
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.
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.
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.
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.
Figure 15.7 Reduction of 2nd Bank's reserves.
Then, we increase 1st Bank's as shown in Figure 15.8.
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.
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.
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 newly issued government bond, this increases the money supply.
If a retail investor purchases a government bond, this doesn't change 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