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The primary way for Governments to fund their deficits is by issuing new currency from the central bank against new treasury bonds.

The Federal Reserve reduced its [balance sheet]1 from 4.4 trillion USD in January 2018 to 3.8 trillion USD in September 2019.

How did the US Government fund its deficit during this period?

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From debt bought by households, firms and foreign governments, as government always did.

This question is based on fundamentally flawed premise that:

The primary way for Governments to fund their deficits is by issuing new currency from the central bank against new treasury bonds.

No, this is not a primary way for most governments to fund its deficit. This might occur during some periods, for example large portions of the new debt US got while fighting covid was financed by Fed purchases, but historically only very small fraction of government spending is funded by expanding money supply.

According to Haslag (1998) empirically:

For most of the countries, money creation accounts for less than 2 percent of real GDP.

Whereas, empirically average government spending to GDP is somewhere around 40% for most countries (see OECD statistics here). Consequently, it is empirically not important source of revenue.

For example, the composition of US government debt by ownership is according to the Committee for Budget Responsibility as as follows:

enter image description here

As you can see the Fed owns roughly 13% of all US government debt. Now that is total debt not a deficit, but total debt is nothing more than accumulation of yearly deficits over time. Consequently, if most of the US deficits were funded by Fed, Fed should also be the biggest owner of US government debt, but clearly empirically it is not, so at least for the US clearly central bank is not responsible for funding most of the deficit generally (i.e. there might be some periods when it is like current covid crisis, but generally it does not do that otherwise it would be biggest holder of a debt).

You will get slightly different picture in each country but for most countries and most of the time it will not be accurate to say that most of the government deficit is funded by central bank. As a matter of fact money creation usually pays only for very small amount of the overall spending.

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  • $\begingroup$ Thank you for this insight. I believe the US enjoys a special status because its Government treasuries are in high demand by foreign investors. In India, for example, >50% of the total debt is owned by the central bank. $\endgroup$ Jan 18 at 5:40
  • $\begingroup$ The domestic debt is held in exchange for currency, which is a liability of the Fed. So, I believe that the debt is effectively owned by the Fed, even if it doesn't appear so on paper. Am I wrong in thinking this? $\endgroup$ Jan 18 at 5:49
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    $\begingroup$ @RiteshSingh no as the graph above shows US domestic debt is still about 3-4x bigger then the debt held by fed. For India it might be true that more than half of a debt is own by central bank but this has nothing to do with US having special status - I could pull out similar pictures for major western countries as well. Countries where central bank holds most of the debt are exceptions. $\endgroup$
    – 1muflon1
    Jan 18 at 11:48

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