Monetary Financing

The concept of monetary financing is covered in this short revision video.

Monetary financing has become more prominent as a possible macroeconomic policy as the covid-19 crisis has engulfed many countries including the UK. The UK government for example has seen their spending surge including the billions spent on the Job Protection Scheme whilst at the same time, tax revenues have dropped sharply. The result has been a dramatic increase in government borrowing.

An article published by the Financial Times in April 2020 read: "The UK has become the first country to embrace the monetary financing of government to fund the cost of fighting coronavirus, with the Bank of England agreeing to directly finance the state’s spending needs on a temporary basis.”

What is monetary financing?

Monetary financing is a direct transfer of money from a central bank for a government to spending. This might involve the direct purchasing of new government debt (bonds) by a central bank.

How does monetary financing differ from quantitative easing (QE)?

Monetary financing (MF) is not quantitative easing (QE) which happens when a central bank makes bond purchases in the secondary market. QE is not meant to be a permanent feature of monetary policy whereas MF is the creation of permanent central bank money.

Monetary financing in 2020

“In response to the COVID-19 pandemic, the USA Federal Reserve will buy unlimited quantities of Treasury bonds, the Bank of England will purchase £200 billion of gilts, and the European Central Bank up to €750 billion of eurozone bonds. Almost certainly, central banks will end up providing monetary finance to fund fiscal deficits.”

Source: Adair Turner, Project Syndicate, April 2020

The process of monetary financing

• Government increases spending and runs a larger fiscal deficit
• Might be to fund an infrastructure project
• Normally financed by issuing new government debt to the bond market
• Central bank can commit to buying some of all of this new debt
• Effectively transfer of money from central bank to the government
• This increases the base money supply in an economy

How might monetary financing help the UK economy?

1. Direct financing of new government debt can be justified in a severe economic crisis e.g. to finance essential fiscal stimulus projects
2. Increasing the money supply during a severe downturn can help to lower the threat of a deflationary depression
3. There is a low risk of inflation if the monetary financing is used to fund government spending at a time when private demand is weak

Risks / drawbacks of monetary financing

1. Biggest fear is that increasing the base supply of money will eventually lead to a steep rise in the rate of inflation
2. Higher inflation effectively acts as a new tax on households as it lowers their real disposable income
3. Monetary financing is commonly associated with disastrous consequences in Zimbabwe, Venezuela and Weimar Germany in the 1920s
4. If a central bank stands ready to fund (directly) new debt, there is less discipline on government borrowing, which might lead to an increase in irresponsible spending /public sector debt