1. Suppose the government runs a deficit... E.g. let government spending on goods and services be $10,000. For simplicity, all transactions are in cash. Let net taxes from all sources be $9,000 so there is a $1,000 deficit.
2. The government has $9,000 in cash from taxes, but needs to spend $10,000. Somehow (print money, borrow money, raise taxes, or lower spending) it must get $1,000 more.
3. Suppose it decides to borrow – issue new debt. Then the Treasury sells a government bond to someone in the private sector for $1,000. The person gives $1,000 in cash to the government and in return gets an IOU (perhaps for, say, $1,100 in one year).
4. The government now has $9,000 in cash from taxes and $1,000 it has borrowed from the public so it can now purchase $10,000 in goods and services.
5. Now let’s do the monetization step. This can happen automatically, as explained below, but for now let’s have the Fed conduct a $1,000 open market operation to increase the money supply. To do this, it cranks up the press, loads in some paper and green ink, and prints a brand new $1,000 bill. It takes the $1,000 bill and purchases a bond from the public, for simplicity make it the same bond the Treasury just issued. Then the money supply goes up by $1,000 (and may go up more through multiple deposit expansion) and government debt in the hands of the public goes down by $1,000 since the Fed now holds the bond. The increase in the money supply is inflationary.
6. What has happened? When all paper has ceased changing hands, the $10,000 in goods and services is paid for by the collection $9,000 in taxes and by printing $1,000 in new currency. The government debt simply moves from the Treasury to the Fed (in the U.S., the Fed pays for its operations from its earnings on these bonds and remits the remainder to the Treasury; I believe the remittance is weekly, but I’m not positive on that). (In other words, the Treasury just ends up owing money to the Fed.)
How can constant interest rate rules potentially cause debt monetization to occur automatically?
Suppose the Fed follows a constant interest rate rule. Further suppose an increase in government spending increases the interest rate (see here for a paper on this by Benjamin Friedman posted at the NBER site today). That is, when the government issues new debt, the supply of bonds increases lowering the price and raising the interest rate. Under these assumptions what will happen when there is deficit spending?
1. Deficit spending financed by borrowing from the private sector causes the interest rate to go up. Thus, initially two things happen, bonds held by the public (debt) increase and interest rate increases as well.
2. But the Fed is following a constant interest rate rule. Seeing the interest rate rising, what should it do? It should increase the money supply and to do so it prints money, as above, and uses it to buy bonds from the public. In order to return the interest rate to where it started, all of the debt issued in step one must be purchased with newly printed money (can you smell the fresh ink?).
3. In the end, what happens? It’s just as above, the entire deficit is financed by printing money and the debt issued by the Treasury ends up in the hands of the Fed
