Rezende_2007_The Nature of Gov Finance in Brazil

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1 
 
 
 
 
 
 
THE NATURE OF GOVERNMENT FINANCE IN BRAZIL 
by 
FELIPE CARVALHO DE REZENDE 1 
University of Missouri–Kansas City 
November 2007 
 
 
 
 
 
 
 
 
 
 
 
 
 
1
 Felipe Rezende is a Ph.D. student in economics at the University of Missouri – Kansas City. Many sincere 
thanks to Professors L. Randall Wray, Stephanie A. Kelton, and John Henry for their valuable comments 
and suggestions. The author would also like to thank Flavia Dantas for valuable discussions and 
suggestions. Any remaining shortcomings and errors are the sole responsibility of the author. 
 2 
THE NATURE OF GOVERNMENT FINANCE IN BRAZIL 
by 
FELIPE CARVALHO DE REZENDE 
University of Missouri–Kansas City 
November 2007 
 
I. INTRODUCTION 
The aim of this paper is to focus on the institutional process by which the 
Brazilian government spends, borrows, and collects taxes. I am going to evaluate the 
conventional view that taxes finance government spending, that bond sales are financing 
operations, and that the Brazilian federal government is financially constrained. Section 
II describes the institutional framework of the Brazilian payment system. In the following 
section, I am going to demonstrate the accounting entries that are made as the 
government spends, collects taxes, and issues bonds. I will also show the nature of the 
coordination between the National Treasury and the Brazilian Central Bank. Section IV 
evaluates the strategies developed by the Central Bank for minimizing the so-called 
operating factors and provides policy proposals for Brazil such as the elimination of 
reserve requirements and the adoption of Treasury Tax and Loan accounts as current 
utilized by the US government. In Section V, I will briefly discuss the nature and origins 
of money as emphasized by the credit approach to money and the state money approach. 
Finally, I will argue that with the floating rate fiat money system adopted in Brazil since 
1999 the government only promises to deliver fiat money. This provides sovereignty and 
policy independency in which the government spends emitting its own liability so that 
once we understand the way that the system works and the possibilities that are given to 
domestic policy it allows us to achieve full employment and price stability. 
 
 3 
II. THE BRAZILIAN PAYMENT SYSTEM 
The new Brazilian payment system was launched on April 2002 by the Brazilian 
Central Bank2. The concept of the new Payment System was based upon the guidelines 
established by the Core Principles for Systemically Important Payment Systems Report 
and the Recommendations for Securities Settlement Systems, both published by the Bank 
for International Settlements. The Sistema de Transferencia de Reservas – (Reserves 
Transfer System) is a real-time gross settlement system (RTGS) for interbank funds 
transfer in which all payments, including clearinghouses netting results, are settled in 
reserve accounts. The Reserves Transfer System is operated by the Brazilian Central 
Bank and any fund transfer among bank reserve accounts depends on sufficient balance 
of funds in the participant account issuer of the bank order. The inter-bank settlement is 
made using central bank money. The Special System of Liquidation and Custody 
(SELIC), which is also operated by the Central Bank, is the central depository for 
securities issued by the federal government and is used for settling federal government 
securities. It settles transactions under a real-time delivery versus payment model (DVP 
Model 1 -Delivery Versus Payment with simultaneous settlement of securities and funds 
on a gross basis) according to the BIS classification. Note that a real-time gross 
settlement system is constantly in need of liquidity, since it settles payments transaction 
by transaction on a real-time basis subject to the availability of sufficient funds. The 
 
2
 The aim of the new Brazilian Payment System was the reduction of systemic risk and the improvement of 
the market infrastructure towards the adoption of the best practices following the international 
recommendations including BIS/CPSS (Bank for International Settlements/Committee on Payments and 
Settlement Systems) and IOSCO (International Organization of Securities Commissions). The Reserves 
Transfer System also requires that banks must maintain positive reserve balances at the Central Bank at all 
times, significantly reducing credit risk. A real time gross settlement system (STR - Sistema de 
Transferência de Reservas) and a national messaging system (RSFN – Rede do Sistema Financeiro 
Nacional) support the functioning of the new infrastructure. (See the World Bank report 2004 for a detailed 
analysis) 
 4 
participation in the Reserves Transfer System is mandatory for both bank reserves 
account holders and entities that operate systemically important settlement systems3. The 
National Treasury also participates in the system, since the Reserves Transfer System 
settles, among others, funds transfers related to the collection of taxes and federal 
government expenditures4. The National Treasury operating account is used to register 
the flows of financial resources from the Fiscal and Social Security budgets. Those 
resources are deposited at the Brazilian Central Bank, which is by law (Federal 
Constitution) the only depositary of the National Treasury balances5. In other words, 
these banks’ reserves accounts are used for clearing among banks, between banks and the 
National Treasury, the Central Bank and clearinghouses (net settlements transfers from 
private clearinghouses). 
In order to understand the nature of government spending and taxing, we have to 
understand the debiting and crediting of bank accounts. Once we understand what bank 
 
3
 According to Brazilian Central Bank Circular 3,057, net positions stemming from systemically important 
clearing system have to be settled in reserve accounts. Clearinghouses that are considered to be 
systematically important are also obligated to maintain a bank reserve account at the Central Bank. Entities 
operating non-systemically important settlement systems can participate in system for reserve transfer as 
well. By legal disposition (Law 4,595), all banking financial institutions are obligated to deposit their 
available funds in reserve accounts held at the Central Bank. Also, by disposition of the Central Bank of 
Brazil (Circular 3,101), all funds transfers between reserve accounts, as well as between reserve accounts 
and clearinghouse’s settlement accounts have to be made through STR. (See The Brazilian Payment 
System for a detailed analysis) The STR processes large-value payments for financial and commercial 
institutions and it also processes final settlements for eight clearinghouses. The total value of payments 
settled through STR over the year of 2005 was R$ 107.4 trillion. According to the Central Bank, “the 
weekly turnover in the STR is approximately equal to Brazil’s nominal GDP. It represents one of the ten 
highest relative turnover systems in the world, and it is roughly equal to the relative values seen in the most 
advanced systems, such as the Fedwire, operated by the Federal Reserve in the US, or Chaps system in the 
UK.” (See The Brazilian Payment System for a detailed analysis) 
3
 “The financial resources of the Brazilian Federal Government must be deposited only at the Central Bank 
in an interest bearing demand deposit account that pays the average yield of the Brazilian federal 
government securities debt that the CB holds in its portfolio, mark-to-market excluded. In 2005, the 
aforementioned yield was 16.11% and 15.28% in 2004.” (BCB Financial Statements 2006, p.37) 
4
 Note that STR participants input only debit authorizations; it means that the seller authorizesa debit to its 
custody account and the buyer authorizes a debit to its reserve account. 
5
 “The financial resources of the Brazilian Federal Government must be deposited only at the Central Bank 
in an interest bearing demand deposit account that pays the average yield of the Brazilian federal 
government securities debt that the CB holds in its portfolio, mark-to-market excluded. In 2005, the 
aforementioned yield was 16.11% and 15.28% in 2004.” (BCB Financial Statements 2006, p.37) 
 5 
reserves are, where they are kept, how this accounting entries are made, what are the 
implications of a debt to bank reserves positions and a credit to bank reserves positions 
we will see that government spending always injects banks reserves and that the payment 
of taxes, on the other hand, reduces banks reserves all else equal. Indeed, when the 
government spends the National Treasury authorizes the Brazilian Central Bank to make 
withdrawals from its operating account making resources available at the Banco do Brasil 
(a state owned commercial bank) which then makes payments to creditors increasing 
demand deposits and bank reserves6. In Brazil, High Powered Money is issued solely by 
the Central Bank and is held as currency by the public and reserves by the banking 
system. It is a government’s IOU in the form of either cash or checking accounts balances 
at the Central Bank7. 
In Brazil, taxes are collected throughout the calendar year into the National 
Treasury operating account kept at the Central Bank in three different ways: taxes 
receipts that are administered by the Secretaria da Receita Federal (Secretariat of Federal 
Revenues - Brazilian Tax Authority) are collected using certificates of collection ; taxes 
receipts that are administered by the social security system are collected using social 
security certificates of collection through the authorized banking network; and taxes 
receipts that are directly collected using Union Tax collection documents kept in the 
Treasury’s reference account held at the Banco do Brasil. It has two days to make the 
 
6
 Since 1999 not all government payments are made through Banco do Brasil, with the adoption of Ordem 
Bancaria para Credito de Reservas Bancarias- Bank Order for Crediting Bank Reserves accounts some 
payments are made directly to the beneficiary’s account. 
7
 There are self-imposed constraints that mandate that the National Treasury can not spend without having 
money in its account or that the creation of permanent spending without a corresponding increase in 
permanent revenue or a reduction in other permanent spending commitments are prohibited. These 
constraints on government spending are necessarily self-imposed. When all is said and done, when tax 
payments are made HPM is destroyed, i.e., the Central Bank debits private’s bank accounts and credit the 
National Treasury’s single account. 
 6 
credit transfer to the Treasury’s single account held at the Central Bank. When taxes are 
collected by means of a certificate of collection, the authorized bank network should send 
the financial resources collected to the National Treasury single account kept at the 
Central Bank within one day. The authorized bank can hold the tax receipts for just one 
more day but, in this case, it must pay interest (the Selic overnight interest rate) to the 
National Treasury. When the Brazilian government spends it does so by crediting bank 
accounts. This procedure occurs through the emission, in the Integrated System of 
Federal Government Financial Administration (SIAFI), of a banking order which 
contains the necessary information for the credit to be deposited in the beneficiary’s 
account, i.e., it issues a bank order in favor of the creditor8. The effective expenditure will 
occur in the next day after the issue of the banking orders by the direct administration 
organs, funds, and autarchies, debiting the National Treasury operating account. This rule 
allows policymakers to forecast the daily flow of government expenditures and its impact 
on the money market as well as the control of the cash flows from the Banco do Brasil. 
III. THE RESERVE EFFECTS OF THE TREASURY OPERATIONS AND THE 
RESERVE ACCOUNTING ENTRIES 
The aim of this section is to demonstrate how the Brazilian government spends, 
that is, how the National Treasury spends and how it collects taxes. I will also evaluate 
the impact of government spending, taxing and bond sales on aggregate bank reserves 
and the significance of the resulting reserve effects. As the National Treasury keeps an 
account at the Brazilian Central Bank (hereafter, BCB), when the treasury spends to buy 
 
8
 After that, at the end of the day, an electronic file is created and sent to the Banco do Brasil. When the 
banking order is processed, the Banco do Brasil credits the beneficiary’s account. This is possible as it is 
authorized to withdraw the amount from the National Treasury’s single account. Federal payments are 
executed crediting bank accounts or through the issue of banking orders. 
 7 
goods, services, assets, and to make transfer payments it does so by debiting its account 
at the BCB. The National treasury’s balance kept at the Central Bank is an asset of the 
National Treasury and it is a liability, as an account kept in the name of the National 
Treasury, of the Central Bank. In short, it is a balance owed to the treasury being nothing 
but an internal claim9. In order to demonstrate how the Brazilian federal government 
spends, one can use T-accounts to reflect changes in balance sheets. Let us consider the 
case in which the government must collect taxes (first imposes a tax liability) before it 
can spend10 (See figure 1 in the Appendix). Note that the banking system is initially at an 
equilibrium level of reserves in which banks held all the reserves that was required or 
desired previous to this operation. We know that government spending injects reserves 
into the banking system. But when citizens pay their taxes bank reserves are destroyed. 
(Bell, 2000; Bell and Wray, 2002-3; Wray 1998; Forstater and Mosler, 2005; Mosler 
1995, 1997-98) 
In this case, when someone pays its taxes he or she writes a check to the 
government, for example, of R$100. The liabilities of the taxpayer are going down by 
R$100. At the same time he or she draws down its assets by R$100 from its demand 
deposit at a commercial bank. As balance sheets have to balance, the taxpayer’s assets go 
down by R$100 and his or her liabilities (taxes owned to the government) go down by 
R$100. The National Treasury receives the tax payment of R$100 in its account at the 
Central Bank. The National Treasury gets the credit of R$100 to its balance at the Central 
 
9
 Thus, operations between the treasury and the Central Bank have no impact on banking system reserves. 
In fact, the National Treasury balance 'accounts' for taxes collected, funds borrowed, etc. This balance kept 
at the Central Bank is not part of any monetary aggregate. Only the balance that the commercial bank has at 
the Central Bank is part of the monetary base. (Bell and Wray 2002-3) 
10
 As Wray (2003-4) emphasized, the “logic dictates that imposition of tax liabilities must come before 
there is a demand for the government’s currency (or, for credits to bank accounts)—“taxes drive money” 
(Wray, 1998). Here we are simply assuming that a tax system, a floating currency, markets and prices 
denominated in the currency, and a hierarchical monetary system (with HPM at the top) already exist. 
 8 
Bank and the offsetting entry is that the reserves from the taxpayer’s commercial bank 
will be reduced by R$100 as well. As the government received a tax payment, the reserve 
balance of the taxpayer’s bank was reduced, i.e., bankreserves were destroyed11. At the 
same time, the taxpayer’s bank deposit was debited. In short, the payment of taxes, all 
else equal, leads to a net decline of bank reserves balances; the banking system as a 
whole is losing reserves. 
Let us now present the case in which the government must first borrow (sell 
bonds) before it can spend12 (See figure 2 in the appendix). If the public purchase a newly 
issued government bond, they simply exchange one asset for another by drawing against 
its checking account at their commercial bank to pay for the bond. (Wray, 2002-3) 
Note that the final position is precisely the same as before, that is, government 
spending injects reserves into the banking system. It spends by crediting bank accounts. 
When the government is spending the banking system gains reserves and when taxes are 
paid to the government High Powered Money (HPM) is destroyed. When taxes are paid 
the Central Bank debits the private bank’s account and credits the National Treasury’s 
account kept at the Central Bank13. By the same token, when the federal government 
 
11
 It should be clear that government tax receipts do not provide funds for government expenditures. As 
Bell demonstrated, “…in order to get its hands on the proceeds from taxation and bond sales, the 
government must destroy what it has collected. Clearly, government spending cannot be financed by 
money that is destroyed when received in payment to the state.” (Bell 2000, p.615) 
12
 When the National Treasury spends it draws down its balance at the Central Bank. For instance, when the 
treasury makes a payment for someone of R$100 the person who receives this will get a deposit of 
equivalent value in a commercial bank. This commercial bank now increases by R$100 the value it owes to 
one of its client and, as balance sheets have to balance, if the right hand side went up by R$100 the left 
hand side has also to increase by R$100. The offsetting entry is that the commercial bank gets a balance of 
R$100 in its account at the Central Bank, i.e., bank reserves have increased by R$100 as well. 
13
 Note that “when the treasury moves its deposit from the private bank to the central bank, the central bank 
must debit the private bank’s reserves. However, the private bank does not have (excess) reserves to be 
debited; hence, the central bank must provide an “overdraft” of loaned reserves. Once the treasury deficit 
spends, the bank’s reserves are credited, allowing it to retire the overdraft.” (Wray 2003-4, p.317) 
 
 9 
deficit spends it generates excess reserves in the banking system14. The increase in 
government spending leads to an injection of bank reserves so that when the government 
increases its expenditures, the banking system as a whole gains reserves. 
Thus, when government taxes more than it spends the banking system loses 
reserves. On the other hand, when the government spends more than it taxes (runs a 
deficit) the net effect is an injection of bank reserves. It should be clear that neither taxes 
nor bonds finance government spending. (See for instance Wray 1998; Wray 2003-4; 
Wray 2003b; Wray 2006a; Bell 2000; Mosler 1995) 
The picture below shows the National Treasury daily balance since the beginning 
of 2007. We can see that at the beginning of every month the Treasury usually runs a 
surplus, that is, government taxes more than it spends. Conversely, we can also see that in 
some periods of time, usually when the civil servants get paid, taxes receipts are less than 
government spending. In this case, there would be excess reserves or a net injection of 
reserves at that period of time, all else equal15. Now, if it was possible to somehow 
coordinate on a daily basis government spending and taxing then there would be no net 
effect on bank reserves balances. It means that we would be able to exactly match the 
increasing of reserves and the losses of reserves so that the balance of bank reserves 
would not be disturbed. 
 
14
 As Wray emphasized, “we have assumed that required (or desired) reserve ratios on the newly created 
demand deposits are zero, but nothing of significance is changed if we allow for positive reserve holdings. 
The government would simply sell fewer bonds since fewer reserves would have to be drained.” (Wray 
2003-4, p.315) 
15
 As Bell argued, “It is impossible to perfectly balance (in timing and amount) the government’s receipts 
with its expenditures. The best the Treasury and the Fed can do is to compare estimates of anticipated 
changes in the Treasury’s account at the Fed…Errors due to excessive or insufficient tax and loan calls are 
the norm….When the Treasury is unable to correct these errors on its own, the Federal Reserve may have 
to offset changes in the Treasury’s closing balance.” (Bell 2000, p.616) In fact, “…daily operations of the 
treasury would almost always generate either net credits or net debits even if the budget were balanced over 
the course of the year for the simple reason that tax payments on any given day would differ from 
government spending on that day.” (Wray 2007, p.26) 
 10 
Figure 3 
 
Source: Brazilian Central Bank 
 
Depending upon where we are in the calendar year there is a net injection or a net 
loss of reserves. Another important point is that the National Treasury daily balance is 
not balanced, i.e., the disbursements and tax collections are not daily perfectly offset and 
that the National Treasury balance at the Central Bank is one of the most important 
operating factors that affect bank reserves balances. Since the net injection of reserves 
will put a downward pressure on the overnight Selic interest rate16, in order to minimize 
these effects the Central Bank engages mainly in open market operations to maintain the 
overnight interest rate close to the target. (Wray 1998; Bell and Wray 2002-03; Bell 
2000) 
 
 
16
 The Selic interest rate is the average interest rate on overnight inter-bank loans collateralized by 
government bonds that are registered with and traded on the Special System of Liquidation and Custody 
(SELIC). It is the overnight interest rate for repo operations that use government debt as collateral. 
 11 
IV. STRATEGIES DEVELOPED FOR MINIMIZING THE RESERVE EFFECTS 
In Brazil, since the adoption of the inflation targeting framework for monetary 
policy in June of 1999, the National Monetary Council (CMN) sets the annual inflation 
target (measured by the IPCA, a consumer price index), and the Central Bank is 
responsible to achieve the inflation target set by the National Monetary Council (CMN). 
In order to achieve its monetary policy objectives, the Monetary Policy Committee 
(Copom) in its meetings sets the target for the overnight Selic rate. Daily open market 
operations are undertaken to maintain the overnight interest rate close to the target17. An 
important definition is that the money market will determine the overnight nominal interest 
rate18. The Central Bank has three basic instruments to stabilize the bank reserves market: 
open market operations, discount window, and reserve requirements. Open market 
operations are undertaken by the Central Bank using federal government debt securities. 
The factors that affect the total amount of reserves are bond sales/purchases made by the 
Central Bank or by the treasury; foreign exchange operations; government spending 
(treasury); tax collection; and currency (coins and paper notes) held by the public19. The 
 
17
 Since, “Financial transactions performed throughout the financial system converge to the market of bank 
reserves. The BCB uses its instruments to influence the market of reserves and, by this means, the level of 
the basic short-term interest rates. More specifically,the operational objective of the BCB is to keep the 
trajectory of the SELIC rate, an overnight market-based interest rate, as close as possible to the target 
established by the COPOM.” (World Bank, 2004, p.85-86) 
18
 The market of bank reserves is the market of first resort in which banks try to rid themselves of the 
excess reserves on a daily basis and so if the banking system is flushed of banking reserves it means that 
there are too many banks willing to lend them but few willing to borrow. The bank reserves market is the 
arena in which banks with too many reserves find banks with too few reserves and they come together and 
take over the loans. When there are aggregate excess reserves banks will lend them on the banks reserves 
market, mostly on an overnight basis and they will be borrowing if they are short of reserves. Note that if 
“there is an aggregate excess of bank reserves, inter-banking lending cannot eliminate the excess reserves. 
Only the government can drain these through bond sales [and] if it refuses, overnight rates would 
immediately fall toward zero.” (Wray 1998, p.103) 
19
 When the Central Bank purchases dollars, it does so by crediting the account of the seller of the foreign 
currency asset increasing reserve balances. Conversely, when the Central Bank sells dollars, it debits the 
account of the buyer so that reserve balances decrease. The effects of these transactions on reserve balances 
are sterilized, or offset, by open market operations. 
 
 12 
Central Bank will try to accommodate supply and demand of money on the reserves market 
to avoid wide fluctuations of the overnight interest rate20. On a daily basis, the Central 
Bank forecasts the market liquidity needs monitoring the main factors that influence the 
monetary base and the bank reserves market. Thus, the Brazilian Central Bank drains 
reserves, mainly through open market operations, to hit the overnight interest target. 
Open market operations (as well as assets and foreign currency sales) have the advantage 
to immediately affect the quantity of excess reserves offsetting daily operating factors 
that influence bank reserves positions maintaining the overnight interest rate close to the 
target. (See Wray 1998, 2006b) As it will be demonstrated below, bank reserves balances 
are deeply impacted when there is a net injection of reserves in the banking system. If 
banks had held all the reserves it desired or required previous to these net injection then 
they will have excess reserves. Since excess bank reserves do not pay interest, banks are 
not going to refuse to buy bonds because they prefer interest-earning alternatives rather 
than non-interest-earning excess reserves. If banks refuse to buy bonds it just means that 
they have all the reserves required and/or desired. In fact, bond sales simply exchange 
one asset for another. If the government decides to pay interest on reserves balances 
 
20
 The demand for reserves is mainly given by reserve requirements and to settle transactions. For each 
bank excess reserves represents a loss equivalent of the opportunity cost. In addition, the management of 
bank reserves must also consider which level of reserves consists the optimum level given reserve 
requirements and transactions needs. The relevant component of the demand for reserves is the level of 
reserve requirements defined by the Central Bank. Thus, banks will manage this on their reserve account, 
since the Central Bank applies a penalty rate given by the overnight Selic rate plus 1400 basis points per 
year. As noted by Mosler (1995), “reserve requirements… are a means by which the Federal Reserve 
controls the price of funds which bank lends” To sum up, we could call this the opportunity cost of excess 
reserves and that this rate reflects the supply and demand in the money market. Note that "reserves balances 
only settle payments or meet reserve requirements means that the demand for them is insensitive to changes 
in the federal funds rate." (Fullwiler, 2005 p.545) The supply of reserves is affected by changes in the 
following: bond sales and purchases undertaken by the BCB and/or by the National Treasury, The Central 
Bank’s operations in the foreign exchange market; National Treasury deposits and withdrawals; Money in 
circulation (held by the public); open market operations; net redemptions of government securities and so 
on. 
 13 
instead of selling bonds nothing is changed because bonds are reserves that earn interest, 
there is no difference between the two (See Wray 1998; Fullwiler 2005). 
 The picture below shows the daily balances of operating factors from the 
beginning of 2007 to the third quarter of 2007. During this period, bank reserves daily 
average around R$ 36 billions. As the National Treasury receipts and expenditures do not 
perfectly offset one another and that, in fact, they can differ by more than R$10 billion 
that would represent, all else equal, a one day increase in banking reserves to R$46 
billions. Such a sharp increment is likely to result in a zero bidding condition in the 
banking reserves market putting a downward pressure on the overnight nominal interest 
rate. 
Figure 4 
 
Source: Brazilian Central Bank 
 
 14 
Market liquidity is also mainly impacted by the purchase of foreign currency in 
the domestic market by the Central Bank to increase the level of international reserves. 
The problem is that when there are aggregate excess reserves in the banking system all 
banks want to lend them resulting in a zero bid condition in the money market. Note that 
such wide fluctuations mean that the Central Bank has a lot of work to do in order to 
minimize the daily operating factors that have an impact on bank reserves balances. In 
order to keep the overnight interest rate close to the target, the Central Bank undertakes 
daily open market operations, mainly through bond sales, to drain these excess reserves. 
Figure 5 
 
Source: Brazilian Central Bank 
As the picture above shows, open market operations are meant to maintain the 
overnight nominal interest rate close to the interest rate target. As Mosler pointed out, “as 
long as the Fed has a mandate to maintain a target fed funds rate, the size of its purchases 
 15 
and sales of government debt are not discretionary.” Indeed, “Open market operations act 
as buffers around the target fed funds rate.” (Mosler, 1995) 
In addition, “As overdrafts in reserve accounts are prohibited in Brazil, cash flow 
deficiencies are financed either through the market or with the BCB. Both charge penalty 
rates, except for intraday rediscount operations with the BCB.” (World Bank 2004, p.86) 
In short, intra-day overdrafts in bank reserves balances are not allowed even during 
trading hours21. The coordination between the National Treasury and the Brazilian 
Central Bank helps to minimize the reserve effects of government taxing and spending. It 
does not provide finance so that government can spend. As a matter of logic the federal 
government is not spending tax revenue, since taxes are collected by debiting bank 
accounts. It means that banks reserves are destroyed; the state is eliminating its own IOU. 
Government spending in excess of tax revenue injects extra reserves into the banking 
system putting a downward pressure on the overnight interest rate. Throughout the day 
the overnight Selic rate can move away from the target but if it looks like the overnight 
Selic interest rate is lower than the target, the Central Bank intervenes using open market 
operations as the main tool for liquidity adjustment of the system. What they do is that 
they drain these excess reserves by selling bonds in order to be as close as possible to the 
nominal interest rate target. (Wray 2003, 2006b) This is called offsetting operating 
factors and what the Central Bank is actually doing is offeringan interest bearing 
alternative (treasury securities) as opposed to non interest bearing accounts at the Central 
Bank (reserve accounts). Selling securities are just an interest rate maintenance operation; 
it is not a finance operation. Thus the government debt publicly held can be seen as an 
 
21
 Intraday credit lines, such as repurchase agreements (repos and reverse repos, were developed in the 
SELIC to enhance liquidity in the secondary market. (See The Brazilian Payment System, 2004) 
 16 
interest rate maintenance account. (Mosler, 1995; Mosler, 1997-98; Wray, 1998) It 
should be clear that the Brazilian government is not financially constrained neither 
revenue constrained nor reserve-constrained. (Bell, 2000; Wray, 1998; Bell and Wray, 
2002-2003) Even though the National Treasury believes that it issues bonds to meet fiscal 
policy needs, we demonstrated that when a payment is made to the National Treasury the 
bank reserve account of the institution on which the payment is drawn is debited and the 
National Treasury account kept at the Brazilian Central Bank is credited so that this 
transaction drains reserve balances from the banking system. Indeed, bond sales are 
undertaken by the government (National Treasury and/or the Central Bank) to drain 
excess reserves and hit the overnight interest rate target. In fact, it is a monetary policy 
operation rather than a financing operation. In the absence of daily open market 
operations the overnight interest rate would fall to zero22. By contrast, the conventional 
view suggests that when the government is running budget deficits it is borrowing from the 
nongoverment sector and that borrowing pushes up the overnight nominal interest rate23. 
In Brazil, since the introduction of the real time gross settlement payment system 
that is in constant need of liquidity, the Central Bank allowed the use of reserve 
requirements during the operating day for payment and settlement purposes. Therefore, 
only balances at the end of day are used to meet reserve requirements. Another important 
 
22
 Note that we “…do not deny that government’s ability to sell government bonds (in other words, to 
substitute interest-earning bonds for non-interest earning HPM) might be somewhat interest rate sensitive. 
At a low interest rate, many of those with HPM might prefer to remain fully liquid; at a high interest rate, 
most might prefer to hold government bonds over HPM.” Wray (2001) 
 What we can deny “is that the government deficit places upward pressure on interest rates” Wray (2001). 
23
 It does so in sort of a loanable funds argument. Because the government is borrowing up on the savings, 
the private firms are competing with the government and it is pushing all the interest rates up. This 
argument completely misunderstands the nature of government finance. In the real world, “unless [the] 
government drains excess reserves that can result from deficit spending, the overnight rate will be driven 
toward zero. This is because excess HPM will always flow first to banks [and] Banks with excess reserves 
offer them in the fed funds market, but find no bidders — hence the fed funds rate will be quickly driven 
toward zero…this [was] how the Bank of Japan [kept] the overnight rate at zero in the presence of huge 
government deficits: all it [needed] to do [was] to keep some excess reserves in the system.” Wray (2001) 
 17 
source of liquidity is that the Brazilian Central Bank extends fully collateralized, 
unlimited and free of charge intraday credit to banks holding reserve accounts. It means 
that the Central Bank provides an intraday credit facility such as a zero-interest intraday 
repo fully collateralized in government securities (with a haircut). If the intraday 
repurchase agreement is not repaid, it turns into overnight repo automatically, that is the 
Selic rate plus 600 basis points p.y. (See figure below). Since May 2002, all open market 
operations are conducted using National Treasury securities because, in compliance to the 
Fiscal Responsibility Law, the Central Bank has ceased to issue securities and the 
National Treasury is the sole issuer of federal securities. 
In this context, the Central Bank only undertakes secondary market operations for 
policy purposes. In fact, National Treasury’s public bond sales and Central Bank’s open 
market operations are both part of the monetary policy strategy24. Bonds are issued on the 
domestic market through public offerings (auctions) to financial institutions, public 
offerings to individuals (called Treasury Direct), and direct issuances for specific reasons, 
as defined by law. The intervention of the Central Bank in managing market liquidity is 
reflected mainly by variations in the account balances of repos and reverse repos. 
 
 
 
 
 
 
 
24
 For this purpose the Brazilian Central Bank, “projects and monitors bank’s liquidity needs in two ways. 
First, the BCB’s Open Market Operations Department (Demab) prepares daily and monthly forecasts for 
the main factors that influence the monetary base and the bank reserves market. Basically, these factors are: 
cash deposits and withdrawals from the banking system by the public; Federal Government tax receipts and 
expenditures, bank reserve requirements, the issuance and redemption of government (National Treasury 
and/or the BCB) securities; foreign exchange operations (purchase and sale of foreign currency) undertaken 
by the BCB. Second, the BCB monitors daily liquidity conditions by consulting 52 financial institutions on 
an ongoing basis.” (Brazilian Central Bank 2007, Investor Relations Group) 
 18 
Figure 6 
BCB’s Liquidity Facilities: Operational Types, Maturities, and Costs 
 
Source: World Bank 2004, p.87 
Open market operations are undertaken to offset the daily impacts on the banking 
reserve positions25. They sell how many bonds it takes to get the overnight Selic rate 
close to the target. As long as the Central Bank sets an overnight interest target, it does 
not have a choice in implementing monetary policy in this scenario. The Central Bank 
cannot be independent of the National Treasury so long as it wants to hit its overnight 
nominal interest rate target; this means it must accommodate the treasury's balance sheet 
eliminating any financial constraint on the National Treasury. The frequency of the 
informal auctions that the Central bank performs depends on daily liquidity conditions 
 
25
 The management of liquidity is mainly done through short-term repurchase agreements (repos); it 
executes repos at informal electronic auctions (known in Brazil as “go-around” auctions) in which only 
primary dealers participate. According to Figueiredo at all, “participation in auctions is restricted to 
financial institutions keeping an account in the SELIC, which is an electronic book-entry system that 
controls the custody and registers all operations regarding domestic government securities. The two parties 
(buyer and seller) must input every transaction in the SELIC and the system makes a two-sided matching of 
their commands. The seller’s position in securities and the buyer’s position in bank reserves are checked. 
The transaction is settled in a DVP (Delivery versus Payment) basis, if and only if securities and cash are 
immediately available”. (Figueiredo, Fachada, Goldenstein 2002 , p.84) 
 
 19 
and/or monetary policy decisions, and they can be used to add or withdraw liquidity. 
Depending on demand, several auctions may be executed in a single day26. 
To sum up, taxes and bond sales do not finance Brazilian government spending. 
Open market operations are used to stabilize the bank reserve market and hit the 
overnight interest rate target; it is just aninterest rate maintenance operation. The Central 
Bank also uses reserve requirements to absorb excess reserves. However, as I will 
demonstrate in the following section, some required reserves such as on demand deposits 
do not earn interest so that this necessarily reduces banks profitability. 
IV.1 THE ROLE OF HIGH RESERVES REQUIREMENTS 
In Brazil, the Central Bank adopts both remunerated and non-remunerated 
required reserves. Required reserves on demand deposits are not remunerated. Required 
reserves on time and savings deposits are remunerated. Financial institutions may be 
required to meet reserves requirements in cash or in federal public securities. Since 
August 2002, the Central Bank implemented the so-called additional reserve 
requirements on demand, time, and savings deposits. The actual reserve requirements 
ratios are: 45% on demand deposits kept in cash at the Central Bank27; 15% on time 
deposits (reserves in public bonds) in which banks obtain the reserve requirement by 
deducting R$30 millions of its time deposits and then applying the corresponding 
 
26
 Furthermore, since February 2003, “the BCB can also interfere in the money market by performing, at its 
discretion, the so-called operações de nivelamento whereby the BCB’s open-market operations desk 
announces to all market participants that it is ready to take or offer unrestricted amounts of reserves through 
overnight repurchase or reverse repurchase agreements at specified penalty rates. These operations target 
those banks that have not been able to level their reserve positions in the market during the day and, when 
made available by the BCB, are often performed at the end of the day, when the secondary market of 
reserves is about to close.” (World Bank 2004, p.87-88) Note that, “The operações de nivelamento should 
not be confused with the informal auctions (go-arounds) that the open-market operations desk performs as 
part of the BCB’s overall monetary policy management to offset liquidity fluctuations generated by central 
bank cash flow. (World Bank 2004, p.87) 
27
 Required reserves on demand deposits are calculated considering the average (demand deposits) daily 
balances by deducting R$44 million of bank’s demand deposits and then it applies the corresponding 
percentage 45% (institutions with RR under R$ 10 millions are exempt). 
 20 
percentage (15%); and 20% on savings deposits that can be met in currency (that in this 
case pays interest) or in securities. For the additional reserve requirements the ratios are: 
8% on demand deposits, 8% on time deposits, and 10% on savings deposits. There is a 
deduction of R$ 100 million applied to the amount calculated (demand resources, time 
deposits and saving deposits). Additional reserve requirements constitute an interest 
bearing (the SELIC interest rate) account28. 
The calculation period for demand deposits is comprised of two consecutive 
weeks, starting on Monday of the first week ending on Friday of the second week. Also, 
for the calculation period, there is a one week lag between groups A and B. The 
settlement period starts on Wednesday of the second week of the calculation period to 
Tuesday of the following week. Note that the settlement period is also of two consecutive 
weeks and it overlaps with the last three days of the calculation period. During the 
settlement period (there is also a one week lag between groups A and B), the daily 
required reserves balances that must be held in a non-interest bearing account can not be 
lower than 80% of the average balance daily required. If daily balances of required 
reserves are overdrawn by more than 20%, the cost of this deficiency is the overnight 
interest rate plus 1400 basis points. Note that since the introduction (September, 2001) of 
reserve requirements on time deposits and the additional reserve requirements as a 
remunerated balance (August, 2002) there is a sharp increase in the reserve requirements 
that are remunerated (interest bearing balances) (See figure below). Given high reserve 
requirements on demand deposits and considering that they are not remunerated, banks 
 
28
 See the following Brazilian Central Bank current regulations on the rates, deductions and reserve 
requirements: a) on demand deposits, see Circular 3199; b) on time deposits, see Circular 3091 and 3127; 
c) on additional reserve requirements (demand deposits, time deposits and savings account deposits), 
Circular 3157. 
 21 
must economize on deposits or keep them as low as possible since non-interest bearing 
requirements are costly to banks and can encourage substitution to other forms of 
liquidity for bank deposits29. 
Figure 7 
 
Source: Brazilian Central Bank 
Not surprisingly, as the figure below shows, banks started to encourage their 
clients to use time and savings deposits since they constitute interest bearing balances as 
opposed to demand deposits that are non interest bearing balances (the exception is the 
case of additional requirements in which as said above 8% are remunerated). These 
 
29
 In Brazil reserve requirements have been used by the Central Bank as a tool to constraint credit 
expansion and thus it is seen as an alternative to help stabilize prices. However, reserve requirements place 
no significant constraint on lending. Banks extend loans and create deposits. In order to hit the overnight 
interest rate, the Central Bank must accommodate the extra demand of bank reserves. It means that Central 
Bank behavior is not discretionary. In fact, non remunerated reserve requirements are a cost that contributes 
to the level of bank spreads. Thus lower reserve requirements can help reduce bank spreads and interest 
rates charged on loans. 
 22 
changes have been the result of banks reactions to profit opportunities in the money 
market. (See Wray 1990 for a similar analysis) 
Figure 8 
 
Source: BCB Brazilian Central Bank 
Finally we can see the evolution of interest bearing balances opposed to non 
interest bearing balances (figure below). As of January 2000, the total of balances that 
were remunerated corresponded to 50% of the total balances (both remunerated and non-
remunerated). On the other hand, as of January 2007 the total of balances that were 
remunerated corresponded to 75% of the total balances. It corresponds to a situation in 
which the Central Bank decides to pay interest on different types of reserve balances 
(demand, time and savings deposits). In fact, it would be a lot easier for the Central Bank 
to adopt this procedure. In order to stabilize the bank reserves market, the Brazilian 
Central Bank could adopt the framework that is used in Canada in which there is an 
 23 
explicit operating band for the overnight rate that constitutes an upper limit and a lower 
limit for desired target for the nominal overnight rate so that this band allows the 
overnight interest rate to fluctuate within a range of 50 basis points (above or below the 
nominal overnight rate target). (See Fullwiler 2005 for a detailed analysis) 
Figure 9 
 
 Source: Brazilian Central Bank 
Furthermore, the Central Bank can successfully maintain the overnight rate within 
its announced operating target band without relying on reserve requirements30. As Sellon 
and Weiner argued, “The experience of Canada, the United Kingdom, and New Zealand 
 
30
 The Central Bank would pay interest on excess reserves balances (see Fullwiler 2005). As noticed by 
Mosler (1995),”the Interest Rate Maintenance Account (IRMA)…could consist entirely of overnight 
deposits by member banks of the Fed, and the Fed could support the fed funds rate by paying interest on all 
excess reserves.” The Central Bank could create a band corridor inwhich the overnight interest rate would 
fluctuate. As Sellon and Weiner emphasized, in Canada “clearing institutions with a settlement balance 
deficiency at the end of the day [would] be able to finance this deficiency by obtaining a collateralized 
overdraft at the Bank Rate. The Bank Rate will serve as the upper end of the operating range for the 
overnight rate since institutions would be unlikely to pay more than the Bank Rate to secure additional 
settlement balances. Similarly, the Bank will pay interest on positive balances held at the end of the day at a 
rate 50 basis points below the Bank Rate. This rate paid on settlement balances will serve as the lower end 
of the operating range since institutions would not accept a lower rate on positive balances in the market. 
(Sellon and Weiner, 1997 p.12) 
 
 24 
shows that monetary policy can be conducted without the use of reserve requirements” 
(Sellon and Weiner 1997, p.22) As reserve requirements constitute a tax on banks, the 
Central Bank could eliminate reserve requirements and pay interest on positive balances 
(it could be 50 basis points below the overnight interest rate). This would serve as a lower 
limit for the overnight interest rate since banks would not accept a lower rate on positive 
balances. (Fullwiler, 2005; Sellon and Weiner 1997) 
In coordinating taxes and government spending to try to manage the reserve 
effects of those two operations, it gives the illusion that the government must somehow 
match tax receipts with government expenditures. It helps to foster the misleading idea 
that taxes are needed to finance government spending and that the coordination between 
the treasury and the Central Bank is done to meet fiscal policy needs. It supports the 
conventional view that taxes finance government spending because, otherwise, why 
would the government work so hard to make sure that taxes receipts come in to offset 
government spending? But, as I have argued, the coordination between the National 
Treasury and the Central Bank is done for practical reasons to minimize the effects on 
bank reserve positions. Government spends crediting bank accounts and collects taxes by 
debiting them. This is the way it is actually done, that is, how the government spends and 
collects taxes31. Furthermore, as it is impossible for the National Treasury to accurately 
forecast its receipts and expenditures on a daily basis the Central Bank and the National 
 
31
 As Wray affirmatively pointed out, “The government does not ‘need’ to ‘borrow’ its own HPM in order 
to deficit spend. This becomes obvious if one recognizes that government bond sales are logically 
impossible unless a) there already exist some accumulated HPM with which the public can buy the 
government bonds, or b) government lends HPM used by the public to buy the government bonds, or c) 
government creates some other mechanism to ensure that sales of bonds to the public do not lead to a debit 
of bank reserves of HPM. Therefore, government bond sales cannot really ‘finance’ government deficits.” 
Wray (2001) 
 25 
Treasury work closely to minimize the operating factors that impact bank reserves 
balances. 
Since in Brazil tax payments are deposited directly into the National Treasury 
account kept at the Central Bank, we observe large daily fluctuations in the bank reserves 
market. This leads to wide swings in the net reserve positions and disruptions to the 
overnight nominal interest rate, all else equal. In order to minimize those disruptions to 
the bank reserves position, we may propose strategies that have been developed in the 
US, such as allow the Treasury to keep its accounts in banks outside the Central Bank, to 
try to better coordinate the flow of government receipts and expenditures. This would 
minimize the frequency and the size of interventions made by the Central Bank. 
IV-2. ALTERNATIVE MEANS OF DRAINING EXCESS RESERVES FROM THE 
BANKING SYSTEM: A PROPOSAL FOR BRAZIL 
There are a number of strategies to help the treasury to minimize the impact of 
those daily operations on the money market. In the US, the main tool that has been 
developed to help the government to better coordinate the inflow of tax receipts and the 
outflow from government spending is the use of Treasury Tax and Loan (TT&L) 
accounts. These are treasury bank accounts kept at specific private banks all across the 
country32. If a bank is designated as a special depository it can hold those accounts in the 
name of the US government. The other strategy adopted is the coordination with the 
Federal Reserve, and finally the management of these two. Even the orthodoxy has 
recognized that: 
 
32
 These banks are sometimes called special depositories. There are certain criteria that the bank must meet 
in order to become a special depository. One of the requirements to be a special depository is that a bank 
agrees to hold a certain amount of government debt so that it is guaranteeing a buyer for government bonds 
in having a bank designated as special depository. 
 26 
“Given the institutional idiosyncrasy that tax and loans accounts 
must be in the Central Bank (this is a constitutional clause), the Central 
Bank has a lot of work deriving from the administration of the Treasury’s 
accounts. In days when the civil servants get paid, the Treasury first 
transfers the funds to the banks, and the Central Bank must conduct 
contractionary open market operations to mop up the banks’ excess 
liquidity until actual payments are made. Conversely, in days were [sic] 
the banks are due to transfer to the Treasury the taxes they have collected, 
the Central Bank must conduct expansionary open market operations to 
replenish the banks with reserves. If it did not act in this way, the basic 
interest rate would fluctuate wildly. This is a very interesting feature of the 
Brazilian monetary system: because the interest rate would fluctuate too 
much if the Central Bank did not intervene often, it ends up intervening so 
strongly as to shut off completely any intraday variability in the basic 
interest rate.” (Garcia 2002) 
 
In the United States, when the private sector makes payments to the IRS most of 
them does not go directly to the Treasury account at the Fed. Most of the receipts are 
deposited into the Treasury Tax and Loan (TT&L) accounts. When the private sector 
makes its tax payment during the clearing process the IRS sends the check to one of the 
over ten thousand banks in which these special accounts are kept in the name of the 
treasury helping the treasury to coordinate its taxing and spending. “In this case, tax 
payments merely move reserves within the banking system.” (Wray 1998, p.115) The 
Treasury goal is to maintain US$ 5 billion in its account at the FED. The Fed and the 
Treasury are in daily contact so that they can forecast the impact of government taxing 
and spending on its account. (Bell 2000) For instance, they try to predict how much is 
going to be deposited directly to its account in the following days and how much it is 
going to be presented for payment. Based on this forecast they anticipate the flow of 
funds to its account so that they use their tax and loan (TT&L) accounts to transfer 
 27 
money over33. It means that calls are schedule based on forecasts about how much is 
going to be presented for payment the following day, the following week, and so on. 
Based on these forecasts the Fed will schedule calls in order to minimize the impacts on 
reserves. As Wray argued, “The simultaneity of the transfer from tax and loan accounts 
and Treasury spending is due to necessity of stabilizing bank reserves.” (Wray, 1998, 
p.116) If the Treasury forecasts that it will end up having checks cleared (that is, 
outstanding checks are going to be presented for payment) the result is that they aregoing 
to be short by the same amount. If they forecast that they will end up below their target 
they place a call on this account. They call up in order to transfer money from TT&L 
accounts to its account at the Fed. This transfer causes banks to lose reserves. The goal is 
to minimize the impact on bank reserves and to avoid daily disruptions on the fed funds 
market requiring as little intervention as possible by the Fed. If they forecast that tax 
receipts will increase much more than disbursements, the Fed can anticipate that the 
banking system will be short of reserves so that they use open market operations to inject 
reserves to the level desired to hit the overnight interest rate target. When the government 
anticipates deficit spending it sells bonds in order to minimize the reserve effects of the 
Treasury operations on bank reserves position. The treasury announces that it will auction 
government securities specifying which of these bonds are eligible for purchase by the 
special depositories and what percentage of these bonds is eligible for purchase by 
crediting TT&L accounts. When bonds are sold in advance to banks, those funds can be 
 
33
 As noted by Bell and Wray, “…since calls on TT&L accounts are scheduled in advance, and actual tax 
receipts cannot be known with certainty, the reserve effect cannot be completely neutralized. When, for 
example, too few funds are transferred from TT&L accounts, the reserve injection from government 
spending will outweigh the reserve drain and the overnight lending rate will decline.” When this happens 
the government can “…sell bonds to banks or the nonbank public in exchange for existing deposits… 
whereby they will serve as an ex post coordination tool.” (Bell and Wray 2002-3, p.268) 
 28 
transferred simultaneously with the government spending so that there is a destruction of 
money and creation of money at the same time so that the disruption on the bank reserves 
is minimized helping to stabilize the fed funds market. (See Bell 2000; Wray 1998 for 
detailed analyses) 
Since in Brazil the most important monetary tool that has been used is the auction 
system used for National Treasury's public offerings and Central Bank's open market 
operations, it results that it has to intervene more frequently in order to stabilize the bank 
reserves market. All of these machinations help to foster the belief that the National 
Treasury is somehow following this procedure to ensure it will have enough receipts to 
pay its bills on a daily basis by coordinating flows and outflows. However, as I have 
demonstrated, the National Treasury does not need to issue bonds to meet fiscal policy 
needs. In other words, “the federal government does not need to have its own IOU 
returned before it can spend; rather the nongoverment sector needs the government IOU 
before it can pay taxes”. (Wray, 1998. p.116) 
V. THE CREDIT APPROACH TO MONEY AND THE STATE MONEY 
APPROACH 
The credit approach to money emphasizes that there is a bilateral relation between 
debtor and creditor and they are denominated in the unit of account. When a credit is 
issued, it is an IOU, and the law of credit requires that they have to be accepted back by 
the issuer so that if someone issues an IOU he has to agree to accept his/her own IOUs 
back in payment. The IOUs have to reflux back to the issuer so that if someone is able to 
obtain an IOU and somehow they have got a debt to the issuer they can always retire their 
debt to this person that issued the IOU by delivering to the issuer one of his own IOUs 
 29 
and he/she has to accept it (Innes 1913, 1914). From this perspective, government debts 
are the same way. When the government issues IOUs the government has to accept them 
back in payment. If the government issues an IOU and if someone has a debt to the 
government, the government has to accept it back in payment. This is the fundamental 
nature of credit and debt so that this applies not only to the private issuers but also to the 
public issuers (Innes 1913, 1914; Wray, 1998, 2003a, 2004, 2006a, 2007). The unique 
difference between the government issuer of the IOUs and the private issuer of the IOUs 
is that the government has the ability to impose a tax liability on the public. It has the 
power to impose a tax liability and this is called sovereign power. The government first 
puts the population in debt and then issues IOUs that the population can use to retire their 
debt. Government money is used by the population to retire their IOUs, such as taxes 
denominated in the state unit of account, and then the population has to work to get those 
IOUs in order to pay their taxes. In other words, the government imposes taxes 
denominated in the state unit of account and then issues money things that are used by the 
public to pay their taxes. This implies that government money refluxes in tax payments. 
The value of the government money is then determined by what people have to do to get 
it. We can say that taxes back the domestic currency. (See Wray 1998; 2003a, 2004, 
2006a, 2007) 
On the other hand, the conventional wisdom emphasizes a barter economy in 
which money fulfills its role as a medium of exchange to lubricate the market mechanism 
increasing efficiency and reducing transactions costs. From this perspective, money is 
neither a social relation nor an institution. Instead, it is developed by the market, in which 
individuals are utility-maximizers, to reduce transaction costs and to increase efficiency. 
 30 
In order to give value to the currency, they argue, money is denominated in some 
commodity that has an intrinsic ‘natural’ value such as precious metal (mainly gold). The 
value of money is then determined by the gold used to produce coins or by the gold 
backing paper notes. Under a gold standard, the government is committed to delivery 
gold and this is a true debt burden because the future generations are going to have to 
come up with gold in case people want to convert government’s IOU into gold. Thus, in a 
gold standard there is a real burden involved in government deficits, the government 
really is borrowing. If a nation is not operating under a gold standard, that is if they adopt 
a fiat money system, then it is argued by orthodox economists that it is necessary to 
impose constraints on both fiscal and monetary authorities in order to ensure that it 
operates in a manner similar to the gold standard. It means that the monetary authority 
should adopt a monetary growth rule, constraints on the fiscal authorities to run budget 
deficits and ensure that it can run balanced budget. These are required in order to remove 
discretion from the government and ensure that the economy operates under its ‘natural’ 
laws. In addition, the conventional wisdom believes that the government faces a budget 
constraint according to which government spending is financed by a combination of 
taxes, borrowing or money creation. (Wray 1998, 2006a) 
By contrast, the chartalist approach argues that governments can always buy 
anything for sale in their own currency by issuing currency. In a modern money 
economy, in which a nation issues its own currency operating a floating exchange rate, 
the government is not liable to deliver anything to retire its debt. The government is only 
liable to accept its money back in payment of taxes (Knapp 1924; Wray 1998, 2006a, 
2007). In other words, the state chooses the unit of account. It could be a purely notional 
 31 
unit of account that does not have any physical substance. Actually, when the Brazilian 
government spends it issues money things, currency denominated in the Real -the 
Brazilian unit of account- so that we have coins, paper money, and bank reserves but all 
of these are liabilities of the federal government. In Brazil, the federal constitution 
dictates thatthe Central Bank exercises exclusively the authority to issue money things, 
the Real. It follows that private institutions also create money things denominated in the 
state unit of account- the Real. Thus, bank liabilities, such as bank deposits, are privately 
created money things denominated in the state unit of account. The money supply 
privately created is endogenous since banks extend loans and create demand deposits to 
creditworthy clients (See Wray 1998, 2007 for detailed analyses). In addition, there is 
clearly a monetary hierarchy that drives clearing. Almost everyone needs government 
liabilities and they are the only thing that the government accepts back in payment34. 
(Wray 1998; Bell 2000, 2001) When firms and households make tax payments to the 
government they are going all the way from the very bottom of the hierarchy and they 
have to make a payment to the top of the hierarchy. Note that the state is neither going to 
accept private’s IOUs nor they are really going to accept banks’ IOUs. When the public 
makes tax payments to the treasury using private bank accounts banks are going to make 
payments to the treasury using reserves to pay citizens’ taxes. In fact, people go first to 
the middle of the hierarchy and then banks go to the top the hierarchy for them. Banks do 
 
34
 Furthermore, taxes create and maintain the demand for government money, government spending creates 
government money and bonds sales maintain the desired interest rate. (Forstater, Mosler 2005; Wray 1998; 
Bell 2000) It does not provide the government resources or an asset that they can spend. It allows them to 
destroy money at the same rate as they create it; it allows the state to offset the creation of money with 
some destruction of it. Neither taxes nor bond sales finance government spending; they are altogether 
different ways by which the government can drain reserves. 
 32 
not pay the government with bank’s own liabilities because the government is not going 
to accept them. (Wray 1998; Bell 2001) 
VI. CONCLUSION 
Abba Lerner argued that there are two principles of functional finance. The first 
principle is that the government should not use tax revenue in order to finance its 
spending; rather taxes should be increased only if the non-government sector has too 
much income. In other words, the government should not raise taxes to balance its budget 
it should only raise taxes if the public has too much income. The purpose of taxes is not 
to finance government spending, it is to destroy income. The second principle is that the 
government should sell bonds only if the non-government sector has too much money. 
(Lerner, 1943) If the public has too much money, the interest rates would fall to zero. It 
means that there is an increase in bank reserves so that banks will try to lend these excess 
in the overnight market, pushing down the interest rate. In order to drain excess reserves 
from the banking system, the government sells bonds. By contrast, the loanable funds 
argument is that the budget deficit is absorbing saving and pushing up the interest rate35. 
This argument is misleading because, in the first place, budget deficits increase bank 
reserves and, all else equal, it would actually cause the overnight interest rate to fall to 
zero. Second, budget deficits create savings, it is an injection. A sovereign government 
operating under a floating exchange rate regime does not really “borrow”. Rather, deficits 
allow positive net saving by the non-government sector (Wray 1998). When the 
 
35
 This idea of loanable funds markets suggests that there are some financial resources available so that the 
government enters in competition with private borrowers. From this point of view, when the government 
sells bonds it is borrowing from these limited funds of resources and that is an additional demand. This 
argument does not hold because the tendency would be that when a modern government deficit spends it 
puts a downward pressure on the overnight interest rate. Modern government spends by crediting private 
bank accounts and taxes by debiting them. When government is spending it injects High Powered Money 
in the banking system. Government bonds are sold to drain excess reserves and hit the overnight interest 
rate target. 
 33 
government runs a deficit it is spending more than it taxes allowing positive net savings 
in the form of government liabilities. Government deficits increase savings in a particular 
form, in the form of either reserves or government bonds. Note that this saving is in the 
safest and most liquid asset one can have. If a budget deficit is associated with rising 
overnight interest rate is not because deficits are pushing the interest rate up, it is because 
the Central Bank reacts to a budget deficit by raising the overnight nominal interest rate 
target so that it is a policy reaction. In the real world, we observe that when the government 
runs a deficit the Central Bank raises the interest rate because they believe that deficits are 
inflationary. In order to offset the expansionary stimulus that comes from a budget deficit 
the Central Bank raises the overnight interest rate to try to slow down the economy. It is a 
policy response and there is nothing automatic about this36. (See Wray, 2003, 2006, 2006a, 
2006b) 
However, under a floating exchange rate fiat money system the government only 
promises to deliver fiat money and that cannot be a burden. The government spends 
emitting its own liability. It is just a promise to pay. What backs the government liability 
is that, like any liability, it must reflux back to the issuer and it is redeemable by the 
mechanism of taxation. (Sardoni and Wray 2007; Wray 2006, 2006c; Innes 1914) “In 
reality, government cannot really “spend” tax receipts which are just reductions of its 
outstanding liabilities” (Wray 2006). Only money things denominated in the state unit of 
account will be used to retire the tax liability, that is, the government must accept them 
 
36
 In addition, the conventional view argues that taxes are necessary to pay for government spending and 
that bonds sales are a borrowing operation. They emphasize that government spending must be financed by 
tax revenues, borrowing, or printing money. As we have seen, in reality, the government budget constraint 
notion is not an operational constraint on government spending. Neither taxes nor bonds finance 
government spending. The purpose of taxes is first to create a demand for government’s money and second 
to remove extra income that the public is using that can cause inflation. The purpose of bonds sales is to 
allow the central bank to reach its overnight interest rate target. Bond sales are part of the monetary policy. 
 34 
back in payment37. As Wray pointed out, “the state has first exerted its sovereignty by 
imposing a tax liability on the private sector—which, ultimately, is the reason that the 
non-government sector will accept government liabilities as payment for the goods and 
services government buys.” (Wray 2002, p.32) 
Thus, it is meaningless to discuss about debt or fiscal sustainability and federal 
government solvency38. We should note that with the introduction of the Brazilian Fiscal 
Responsibility Law there are ‘borrowing’ limits and other constrains but these are self 
imposed constraints. This does not mean that the government deficit cannot be too big 
but it does mean that the deficits do not burden even the government or taxpayers, rather 
federal government deficits allow the non-government sector to net save in the form of 
government’s IOUs. Those government’s IOUs will be serviced the same way that 
government spends on anything, that is, by crediting bank accounts. The government’s 
abilityto credit bank accounts is unlimited. Thus, a sovereign government that issues its 
own currency under a flexible exchange rate regime cannot become insolvent. There is no 
burden at all involved in a budget deficit ran by a country with a sovereign currency that 
adopts a floating exchange rate system. (See Bell 2000, Mosler 1995; Wray 1998, 2003c, 
2006, 2006a, 2006c for detailed analyses) 
Second, the effect of budget deficits on the value of the domestic currency is that as 
budget deficits allow the domestic economy to grow faster than the rest of the world is 
growing then a trade deficit could result. One of the primary arguments against running 
twin deficits (a trade deficit and a budget deficit) is that it burdens the nation by 
 
37
 See Wray 1998 and 2006 for a detailed analyses 
38
 On fiscal rules, debt sustainability, government solvency and the Fiscal Responsibility Law see Goldfajn, 
Guardia. “Fiscal Rules and Debt Sustainability in Brazil” Technical Note 39, Brasília: Central Bank of 
Brazil, 2003. Available at http://www.bcb.gov.br/ 
 35 
increasing indebtedness. This argument reflects the confusion of a fixed exchange rate 
and a floating exchange rate system. If a nation is operating under a gold standard, a 
currency board, or a fixed exchange rate, a government deficit could commit the delivery 
of gold (or the anchor currency) and that is a true debt burden because the future 
generations are going to have to come up with gold (or the anchor currency) in case 
people want to convert government’s IOUs into gold (or the anchor currency). Thus, in a 
gold standard there is a real burden involved in government deficits, the government is 
really borrowing. (See Wray 1998, 2006, 2006a, 2006b, 2006c; Mosler 1995) 
The rules of the game that other nations are operating under, mostly self imposed, 
would be consisted with a fixed exchange rate system. In fact, some countries do have 
fixed exchange rate regimes. However, the rules of the game are completely different or 
should be completely different with a flexible exchange rate system. Under this system it 
does not make sense to operate the economy so as to produce continuous trade surplus to 
accumulate dollars, this is not necessary with a floating exchange rate system. In order to 
countries understand that we have a paradigm shift, they have to move from the theory 
and policy that is applicable to fixed exchange rate systems, non-sovereign governments, 
to a new paradigm of sovereignty and policy independence. Once we understand the way 
that the system works and the possibilities that are given to domestic policy, it allows us 
to achieve full employment and price stability. 
 
 
 
 
 
 
 
 
 36 
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APPENDIX