Monday, November 08, 2010
Monetizing debt is thus a two step process where the government issues debt to finance its spending and the central bank purchases the debt from the public. The public is left with an increased supply of base money.
Effects on Inflation
To summarize: a deficit can be the source of sustained inflation only if it is persistent rather than temporary and if the government finances it by creating money (through monetizing the debt), rather than leaving bonds in the hands of the public.
Monetizing the debt can be used as a component of quantitative easing strategies, which involve the creation of new currency by the central bank, which may be used to purchase government debt, or can be used in other ways.
However, there can be an insidious effect:
When governments reach the point where they are borrowing to pay the interest on their borrowing they are coming dangerously close to running a sovereign Ponzi scheme. Ponzi schemes have a way of ending unhappily. To get out of the Ponzi trap, governments will have to increase tax revenues, or cut spending, or monetize the debt--or most likely do some combination of all three. (Wiki)