Should Monetary Finance Remain Taboo?
IMF Blog, February 22, 2022
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Bibliographic details
- Authors: Itai Agur, Damien Capelle, Giovanni DellAriccia, Damiano Sandri
- Published: February 22, 2022
Overview
- Authors: Itai Agur, Damien Capelle, Giovanni Dell’Ariccia, Damiano Sandri
- Publication date: February 22, 2022
- Central question: Whether central banks should expand their toolkit to include monetary finance—the financing of government via money creation—especially in exceptional crises.
- Historical context:
- Milton Friedman’s “helicopter” metaphor: a permanent increase in the monetary base to stimulate aggregate demand in a liquidity trap.
- 1970s experience and later episodes where monetary policy became subordinate to fiscal needs led to monetary finance becoming taboo.
- Noted historical collapse example: Zimbabwe in 2007-08.
For and against monetary finance
- Arguments in favor:
- Stronger effect on aggregate demand than debt-financed fiscal stimulus because there is no increase in public debt and no need for future tax hikes.
- May prevent self-fulfilling runs on government debt by allowing the central bank to partially monetize debt and thereby avert default, especially if the central bank credibly commits to intervene only in such runs.
- Arguments against:
- Risk of fiscal dominance: monetary policy decisions becoming subordinate to fiscal needs.
- Loss of confidence in central bank’s ability to keep inflation low and stable could lead to hyperinflation (historical example: Zimbabwe in 2007-08).
- Central bank independence is threatened, undermining anti-inflation credibility.
Inflation risks — empirical approaches and findings
- Empirical approaches used:
- Association analysis between the monetary base and inflation across several countries back to the 1950s.
- Event-study of unconventional monetary policy (UMP) announcements in response to the start of the COVID-19 pandemic in 2020.
- Findings from monetary-base analysis:
- Monetary expansion has modest effects on inflation in countries with:
- strong central bank independence,
- low initial inflation,
- small fiscal deficits.
- Effects are much stronger when:
- central bank independence is weak,
- inflation is high,
- fiscal deficits are large.
- Non-linear effects detected: small expansions of the monetary base → modest inflation increases; large monetary expansions → much stronger inflation effects.
- Findings from UMP/COVID-19 episode:
- Sample: 49 advanced economies and emerging markets and developing economies (EMDEs) during the period between March and December 2020.
- Most countries implemented asset purchases in secondary markets within QE programs (temporary increases in the monetary base, with an expectation of eventual unwind).
- Several EMDEs included direct government financing (DGF) features: purchase of government bonds in primary markets, extension of loans and grants to the government—programs resembling monetary finance.
- Result: No evidence of systematic effects of UMP announcements on inflation expectations, including when focusing on DGF programs in EMDEs.
- Important caveat: these operations were relatively modest in size and likely perceived as one-off interventions.
Policy implications and recommendations
- Explore conditions under which monetary finance may be appropriate in exceptional circumstances, given conceptual pros and cons and empirical findings.
- Constraints and safeguards recommended:
- Any experimentation should be modest in scale.
- Limit experimentation to countries with:
- credible monetary frameworks,
- low inflation,
- sustainable fiscal positions.
- Monetary finance operations should be:
- decided exclusively and independently by central banks,
- aimed solely at ensuring economic stability.
- Recognition of practical difficulty:
- Achieving strict central bank independence for such operations is difficult; some argue this difficulty justifies banning monetary finance altogether.
- Historical misuse under inappropriate circumstances has had devastating economic and social consequences.
Conclusion
- Monetary finance can provide helpful policy support in exceptional times but carries serious risks tied to central bank independence and inflation.
- Empirical evidence suggests modest inflationary effects in well-governed settings and larger risks where institutional and fiscal vulnerabilities exist.
- Any use should be cautious, limited, and governed by strong institutional safeguards.
Source: IMF IMFBlog article "Should Monetary Finance Remain Taboo?" by Itai Agur, Damien Capelle, Giovanni Dell’Ariccia, Damiano Sandri, February 22, 2022.
