(3) Bank Reserves — Total Amount Driven by Fiscal Policy

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Government (central bank) fiscal stance drives the amount of bank reserves in the system. Government spending adds bank reserves, fiscal drag lowers overall bank reserves. When government spends reserves increase, banks may even come to hold excess reserves that they are keen on getting rid of, if they do not receive any/sufficient interest on them. Hence, they try to lend reserves to other banks in need of them. This can end up in a race to the bottom (zero percent interest), as any positive interest income is better than holding non-interesting paying reserves.

If the government is targeting a 3% interest rate, competitive interbank lending may pass below this level compromising government`s monetary target. 

At this, point the central bank begins to sell bonds to the banks, seemingly in an act of borrowing funds from them. In truth, this has nothing to do with borrowing funds; selling government debt is designed to stop banks from lowering the interest rate below the level desired by the central bank. With the central bank setting the debt's yield at an appropriate level banks will no longer have an incentive to drive down the interest rate below the target rate.

Thus, government "borrowing" is really a monetary operation (in defense of a desired level of interest rates) rather than a fiscal activity (to garner funds to be able to spend).

Exogenous factors (like deficit spending) impact on the amount of reserves in the banking system. If nothing is done about the reserve excess that emerges defined as supply being greater than demand, the overnight interest rate drops and the BOJ loses control of its interest rate target (unless it is zero) as the interbank rate heads south to zero. 

Note that we are in the domain of monetary policy. The fiscal policy decisions have been made and executed – sovereign governments spend by crediting bank accounts or issuing cheques which end up in bank accounts. These actions add to reserves. If net spending is positive then bank reserves will rise and vice versa (if tax receipts are greater than government spending). 

In the case of a budget surplus, bank reserves are destroyed and vanish from the system. The private sector feel the impact of the surplus because there is less income to spend and less employment and less public infrastructure provision and more. But the banking system just notes a decline in reserves. The surpluses do not “go anywhere” – into storage for later use. The transactions are recorded electronically, the bank reserves adjusted and everyone goes home for the night. 

Thus borrowing is about monetary policy. This is a major flaw in mainstream macroeconomics textbooks which always have the borrowing in the fiscal policy chapter based on the flawed – backwards logic that the debt funds spending. 

Public borrowing is a monetary policy act because it is one of the means that central bank can use to drain excess bank reserves which stops interbank competition undermining its interest rate target each day. It has nothing at all to do with funding the government spending. That is done and dusted! But the net spending (positive or negative) impacts on the bank reserves and requires a monetary policy response. 

It couldn’t be clearer than that. Budget deficits put downward pressure on interest rates. Financial crowding out does not occur via budget deficits.

The source.