Answer to Question #224888 in Macroeconomics for Anum naz

Question

What happens when the Fed monetizes a budget deficit? Is this something it should always
try to do? (Hint: Outline the benefits and costs of such a policy over time.)

Answer 1

Federal budget deficit means that the expenditures of the Fed are greater than the revenues. If a budget deficit exists, monetization is one of the approaches used to address the gap. When the Fed monetizes the federal deficit, government expenses are financed through money instead of debt that needs to be repaid in the future. This means the Fed prints money that is used to finance government expenditures or directly buys government bonds from the primary market. Thus, monetization increases the money supply.

Monetization can enable the government to undertake huge recovery programs and also prevent deflation from occurring. However, this approach to financing has some costs. Foremost, monetization is likely to result in uncontainable inflation due to an increase in the money supply. Also, this approach can make the government fail to exercise fiscal discipline since money can easily be printed to finance the budget deficit. Lastly, monetization undermines the credibility of the Fed to undertake inflation targeting.

In conclusion, the costs of monetization exceed its benefits. Therefore, the government should refrain from using monetization as a tool of financing. Monetization should only be used as a last resort.