How Central Banks Monetize Government Debt

Any government that issues its currency can create money without limit. However, due to legal and institutional infrastructures, central banks commonly tax or borrow to spend or invest instead of printing money. Severe economic challenges such as the 2008 financial crisis or the COVID-19 pandemic open the door for discussions on monetary finance or financing government through money creation.

What Is Debt Monetization?

Monetization is the permanent increase in the monetary base to fund the government. Monetization occurs when central banks buy interest-bearing debt with non-interest-bearing money as a permanent exchange of debt for cash. Monetization is not limited to open market operations a central bank conducts to achieve policy targets.

If a government has unlimited money, it could potentially control all resources, essentially “crowding out” the private sector. Modern governments have delegated the responsibility of money issuance to central banks, hoping to keep fiscal policy considerations separate from monetary policy. Since the primary goal of central banks is to maintain price stability, such as a stable inflation goal, governments cannot depend on central banks to fund their operations and rely on tax revenue or borrow money in private markets.

Role of the Central Bank

Central banks can manipulate interest rates, and rates are their target when they carry out their daily open market operations (OMOs) to achieve price stability. The central bank typically states an interest rate goal that will help it achieve its inflation target and increases or decreases the reserves of commercial banks through asset purchases, typically in the form of short-term government bonds.

Quantitative easing (QE) has extended these purchases to other assets like mortgage-backed securities (MBS) and long-term government debt. By purchasing government bonds in private markets, a central bank keeps interest rates low and monetizes government debt. Some central banks purchase bonds via secondary markets and also provide direct funding. Both risks and returns of monetization must be weighed.

The willingness of the private sector to hold government debt depends on the return and riskiness of that debt relative to alternative investments. Any government that issues debt far above what it could collect in taxes is perceived as a risky investment and will likely have to pay higher interest rates.

The Bottom Line

Central banks commonly tax or borrow to spend or invest with the goal of maintaining price stability. Monetization is the permanent increase in the monetary base to fund the government. The Nobel Laureate, Milton Friedman, equated monetary finance policy to dropping money from a helicopter. However, any excessive printing of money or subsequent spending may lead to inflation, hyperinflation, and then abandonment of the currency.