Redefining monetizing government debt

Daniel Thornton of St Louis Fed has an excellent note on the topic.

Monetizing debt implies central bank buys bonds of the government by printing currency. This was a common practice a few years ago leading to hyper inflation etc. Central Banks were not independent entities and seen as agents of government. Then  came central bank independence and we had a focus on price stability. Then came this crisis and questioned everything under the sun. Central banks were again buying government bonds leading to questions over monetisation of debt.  

 Thorton says we need to re-define debt monetization concept. What matters is the purpose for which central banks are buying debt. 

 The idea that the Fed monetizes government debt by the simple act of exchanging money for government debt is too narrow and uninteresting because the Fed conducts monetary policy primarily through open market operations— buying and selling securities—most often government high-powered money (also known as the monetary base) increases.

 When it sells securities the monetary base decreases. If “monetizing the debt” is defined as the act of converting government debt to money, there would be no reason to ask, “Has the Fed monetized the debt?” The answer would be simple: “Yes, every time it purchases government securities.”

Now, we cannot call this monetisation of debt. This is how Fed (and other central banks) conduct monetary policy. 

He suggests that an economically meaningful definition of “monetizing the debt” must be based on the Fed’s motive for increasing the money supply. If Fed buys bonds for its normal monetary policy operations, it is not monetization of debt. However, there is a problem trying to differentiate between motivation aspect versus actions taken by the Fed.

First, it is difficult to determine whether debt purchases are solely driven by the Fed’s policy. Second, the Fed increases the monetary base whenever it purchases any asset—not only when it purchases government debt. This increase in monetary base could be used by private sector to purchase govt debt. So a central bank does not really need to buy govt debt to monetize it. It can do it via indirect ways as well.

 So what can be done?

The only effective way to determine whether the Fed (or any central bank) has monetized debt is to compare its performance relative to its stated objectives. Many central banks have adopted a numerical inflation target. If inflation is running above the target when the government is faced with a debt-financing issue, one might suspect that the central bank is monetizing the debt. The Fed has not adopted a specific numerical inflation target, which makes it more difficult to determine whether its actions are purely motivated by its policy objective. In general, the more explicated a central bank is about its policy objectives, the easier it is to determine whether it is monetizing the debt.

A great thought to work on. The crisis has create a lot of damage but it is helping redefine and rethink economics in a big way.


8 Responses to “Redefining monetizing government debt”

  1. Aryan Vaid Says:

    Dear Amol,
    Brilliant stuff! IIP, Inflation … really great. One suggestion: Could you please focus more on India? Could you also post an alert on important economic events (like data release) on India? Focus more on India..may be like Ajay Shah you can post a note on important readings. Please keep your postings short…no one has really patience to read long story. Keep short and direct people to sources if they want to read more.

    Hey! why are your research reports which you used to write earlier? Please post it here also.


  2. Amol Agrawal Says:

    Hi Aryan,

    Thanks for all the comments. Actually I also write long posts to help build clarity at my end. You know writing helps a lot. I do try and cut short on the content bit. I also do try and post just snippets of papers now.

    Actually IIP and WPI were the first posts. Next time will cut it short.

    As far as India related research is concerned, I try really hard to find some good stuff. Most of the good research onm Indian economy comes from foreign sources and it is not very frequent. But yes, I will still try and post more India stuff.

    The research papers I did have stopped as of now. There is little time. I try and make most of my points on the blog now

  3. Nancie Hommer Says:

    I have been hunting almost everywhere for this specific stuff… I am glad anybody honestly has got the answer to a real straightforward concern. You might have simply no understanding what number of websites We’ve been to throughout the last hr. Thx for your resources

  4. Jan Rizzuti Says:

    I can’t figure out why yahoo sent me to your site but I should probably I am now actually interested by the site conent you have aggregated together. How many week did it take this many people to your website? I am pretty darn to this web site stuff.

  5. Hugo Says:

    Sorry, but this is nonsense. The central bank sets the cpi rate its aiming at and then it monetizes government debt (or whatever) to obtain that. So what? Does it make any difference that Bernanke previously said that its aiming at 1%, 2%, 3%, etc… The fact of the matter and what economist should study is that this actions are shifting resources from one place to another and changing the development of the market.

  6. Monita Says:

    Dear Amol,

    Appreciate your efforts, nice stuff, very helpful.


  7. Bless you Says:

    simply click here…

    […]Redefining monetizing government debt « Mostly Economics[…]…

  8. Gangipogu Jaya kumar Says:

    if central bank more indepentent then problem will be reduce….noneless politicaines take action on this as soon as possible…..then only country currency sounding…..

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