Money creation

The authority through which monetary policy is conducted is the central bank of the nation. The mandate of a central bank typically includes either one of the three following objectives or a combination of them, in varying order of preference, according to the country or the region: Price stability, i.e. inflation-targeting; the facilitation of maximum employment in the economy; the assurance of moderate, long term, interest rates.[4]

The central bank is the banker of the government[note 5] and provides to the government a range of services at the operational level, such as managing the Treasury's single account, and also acting as its fiscal agent (e.g. by running auctions), its settlement agent, and its bond registrar.[5] A central bank cannot become insolvent in its own currency. However, a central bank can become insolvent in liabilities on foreign currency.[6]

Central banks operate in practically every nation in the world, with few exceptions.[7] There are some groups of countries, for which, through agreement, a single entity acts as their central bank, such as the organization of states of Central Africa, [note 6] which all have a common central bank, the Bank of Central African States; or monetary unions, such as the Eurozone, whereby nations retain their respective central bank yet submit to the policies of the central entity, the European Central Bank. Central banking institutions are generally independent of the government executive.[1]

The central bank's activities directly affect interest rates, through controlling the base rate, and indirectly affect stock prices, the economy's wealth, and the national currency's exchange rate.[4] Monetarists and some Austrians[note 7][8] argue that the central bank should control the money supply, through its monetary operations.[note 8][9][10] Critics of the mainstream view maintain that central-bank operations can affect but not control the money supply.[note 9]

Open-market operations (OMOs) concern the purchase and sale of securities in the open market by a central bank. OMOs essentially swap one type of financial assets for another; when the central bank buys bonds held by the banks or the private sector, bank reserves increase while bonds held by the banks or the public decrease. Temporary operations are typically used to address reserve needs that are deemed to be transitory in nature, while permanent operations accommodate the longer-term factors driving the expansion of the central bank's balance sheet; such a primary factor is typically the trend of the money-supply growth in the economy. Among the temporary, open-market operations are repurchase agreements (repos) or reverse repos, while permanent ones involve outright purchases or sales of securities.[11] Each open-market operation by the central bank affects its balance sheet.[11]

Monetary policy is the process by which the monetary authority of a country, typically the central bank (or the currency board), manages the level of short-term interest rates[note 10][12] and influences the availability and the cost of credit in the economy,[4] as well as overall economic activity.[13]

Central banks conduct monetary policy usually through open market operations. The purchase of debt, and the resulting increase in bank reserves, is called "monetary easing". An extraordinary process of monetary easing is denoted as "quantitative easing", whose intent is to stimulate the economy by increasing liquidity and promoting bank lending.

The central bank, or other competent, state authorities (such as the treasury), are typically empowered to create new, physical currency, i.e. paper notes and coins, in order to meet the needs of commercial banks for cash withdrawals, and to replace worn and/or destroyed currency.[14] The process does not increase the money supply, as such; the term "printing [new] money" is considered a misnomer.[1]

In modern economies, relatively little of the supply of broad money is in physical currency.[note 11]

"Monetary financing", also "debt monetization", occurs when the country's central bank purchases government debt.[29] It is considered by mainstream analysis to cause inflation, and often hyperinflation.[30] IMF's former chief economist Olivier Blanchard states that

governments do not create money; the central bank does. But with the central bank's cooperation, the government can in effect finance itself by money creation. It can issue bonds and ask the central bank to buy them. The central bank then pays the government with money it creates, and the government in turn uses that money to finance the deficit. This process is called debt monetization.[31]

The description of the process differs in heterodox analysis. Modern chartalists state:

the central bank does not have the option to monetize any of the outstanding government debt or newly issued government debt...[A]s long as the central bank has a mandate to maintain a short-term interest rate target, the size of its purchases and sales of government debt are not discretionary. The central bank's lack of control over the quantity of reserves underscores the impossibility of debt monetization. The central bank is unable to monetize the government debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to any support rate that it might have in place for excess reserves.[32]

Monetary financing used to be standard monetary policy in many countries, such as Canada or France,[33] while in others it was and still is prohibited. In the Eurozone, Article 123 of the Lisbon Treaty explicitly prohibits the European Central Bank from financing public institutions and state governments.[34] In Japan, the nation's central bank "routinely" purchases approximately 70% of state debt issued each month,[35] and owns, as of Oct 2018, approximately 440 trillion JP¥ (approx. $4trillion)[note 15] or over 40% of all outstanding government bonds.[36] In the United States, the 1913 Federal Reserve Act allowed federal banks to purchase short-term securities directly from the Treasury, in order to facilitate its cash-management operations. The Banking Act of 1935 prohibited the central bank from directly purchasing Treasury securities, and permitted their purchase and sale only "in the open market". In 1942, during wartime, Congress amended the Banking Act's provisions to allow purchases of government debt by the federal banks, with the total amount they'd hold "not [to] exceed $5 billion". After the war, the exemption was renewed, with time limitations, until it was allowed to expire in June 1981.[37]