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The public policy blog of the American Enterprise Institute
Buying and selling government securities is mostly how the Fed conducts monetary policy. Sometimes it creates money — using it to purchase Treasuries to lower interest rates — and sometimes it destroys money — selling the Treasury debt it owns to raise rates. So, as a new paper from the St. Louis Fed explains, “there is a sense in which the Fed is “monetizing” and “demonetizing” government debt over the course of the typical business cycle.”
But the phrase “monetizing the debt,” when properly used, refers to the Fed’s use of money creation as a permanent source of financing for government spending. So whether the Fed’s actions of recent years amount to monetizing the debt hinges on intent and duration. Is its enlarged balanced sheet a permanent state of affairs or not?
If the recent rapid accumulation of Treasury debt on the Fed’s balance sheet constitutes a permanent acquisition, then the corresponding supply of new money would be expected to remain in the economy (as either cash in circulation or bank reserves) permanently as well. As the interest earned on securities held by the Fed is remitted to the Treasury, the government essentially can borrow and spend this money for free.
If, on the other hand, the recent increase in Fed Treasury debt holdings is only temporary (an unusually large acquisition in response to an unusually large recession), then the public must expect that the monetary base at some point will return to a more normal level (through sales of securities or by letting the securities mature without replacing them). Under this latter scenario, the Fed is not monetizing government debt—it is simply managing the supply of the monetary base in accordance with the goals set by its dual mandate. Some means other than money creation will be needed to finance the Treasury debt returned to the public through open market sales. For the record, Fed Chairman Ben Bernanke has repeatedly propounded this latter view.
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