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Monetization Defined

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Monetization is the process of converting or establishing something into legal tender. It usually refers to the printing of banknotes by central banks, but things such as gold, diamonds and emeralds, and art can also be monetized. Even intrinsically worthless items can be made into money, as long as they are difficult to make or acquire. Monetization may also refer to exchanging securities for currency, selling a possession, charging for something that used to be free or making money on goods or services that were previously unprofitable.

Monetizing debt:

In many countries the government has assigned exclusive power to issue or print its national currency to independently operated central banks. For example, in the USA the independently owned and operated Federal Reserve banks do this. Such governments thereby disavow the overly convenient ‘slippery slope’ option of paying their bills by printing new currency. They must instead pay with currency already in circulation, or else finance deficits by issuing new bonds, and selling them to the public or to their central bank so as to acquire the necessary money. For the bonds to end up in the central bank it must conduct an open market purchase. This action increases the monetary base through the money creation process. This process of financing government spending is called monetizing the debt. 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 inflated money.

Effects on inflation

When government deficits are financed through this method of debt monetization the outcome is an increase in the monetary base, or the money supply. If a budget deficit persists for a substantial period of time then the monetary base will also increase, shifting the aggregate demand curve to the right leading to a rise in the price level.

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.

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Written by Bill Hurst/ LaFonda Merrick

August 13, 2010 at 1:59 pm

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