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Debt Monetization: The Real Affect On An Open Market

Written by A Forex View From Afar on Tuesday, July 21, 2009

In this article we are going to see what debt monetization is all about, since, lately, there has been a lot of talk about the Fed having to monetize the Treasury’s debt.

Our example’s imaginary government needs to spend about $5000 over a year, but its income is only $4000. Thus, our imaginary government will be forced to run a $1000 deficit, which would need to be funded somehow.

At this point, the Treasury comes into play, taking the task of issuing and selling the $1000 of bonds (IOU’s) to the public, to help the government cover its expenses. Following this process, the private sector will hold $1000 in bonds, but this has the effect of reducing the money supply (less money available for consumer spending), and puts upside pressure on the interest rates.

The imaginary Central Bank (CB) does not want this to happen, so they will step in to the market, and buy $1000 worth of bonds from the private sector. The CB’s purchase increases the money supply by $1000 (excluding the multiplier effect), something that sends yields lower again, to where they were before the bond’s auction.

Everything should look normal by now, but things are not really that good on the inside. The CB increased the money supply by $1000, or considerably more if the multiplier effect is included, which is a huge sum compared to the size of the economy. This will cause inflation, because in the shorter term it shifts the AD (aggregate demand) line to the right, corresponding to higher prices, so long as the AS (aggregate supply) holds steady.

The logical justification of this would be the government uses an extra $1000 to fund spending, thus increasing the demand side of the economy. However, in the short-term, the supply side lags the cash drivers, thus a new equilibrium point is reached (E’), in the short-run, which corresponds to higher prices (P).

This is important because it is happening in the economy right now. Most governments are running deficits (from which some are huge) in order to support the demand side and kick-start the economy. However, deficits – especially the ones monetized by the CB - have a strong inflationary pressure built in, and send the local currency spinning lower. Does these sounds familiar? Think of the dollar now, and we get a very clear picture.

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