Central Bank Borrowing and Inflation: between Myth and Reality

Pandemic covid-19 was a global disaster and every nation was affected with different levels of intensity. Many huge industries such as the aviation and tourism industry faced huge losses. In such circumstances, it was not possible to provide a huge covid support package using the tax revenue. Despite this, many governments including those running deficit budgets for decades provided very large covid relief packages. For example, the UK recorded its last surplus budget in 2002. After 2002, every budget has been a deficit budget. Despite this, UK’s covid support package reaches 18% of their GDP. The tax revenue could never support such a huge spending, so how did the UK manage money for the package? They printed money to provide the package.    

This reminds me of an old debate, sovereign governments are authorized to print money as much as they need, then why do the governments need to collect taxes and why don’t they cover all of their expenses just by printing money? 

In fact, if the governments print money arbitrarily without any economic fundamentals, this may lead to hyperinflation. In the Second World War, Germany chose to print money to meet the expenditures of the War and as a result, German mark lost its value.

More recent example is that of Zimbabwe. Zimbabwe announced to print money to retire public debt and as a result, inflation in Zimbabwe jumped to over one million percent in the next year. In a couple of years, Zimbabwe had to abandon its currency. Therefore, currency printing must be done with extreme care and with careful analysis of economic fundamentals.

But what exactly these fundamentals are? How much money can be created without fear of inflation? This concept is very misunderstood by the academicians and by the policy makers. 

There is very clear difference in practices adapted by the advanced economies and the emerging economies.  Most of the advanced economies used their central banks to create money for Covid support program, but most of the developing nations remain reluctant to do so. So the question is, what is the limit of money printing without invoking inflation?

There is an emerging heterodox school of thought called Modern Monetary Theory having an entirely different perspective on the nature of money. I am not going into the theories and solutions forwarded by Modern Monetary Theory. My analysis entirely lies within the frame work of conventional economics. My observation is, the conventional wisdom on money-inflation relationship is very badly misunderstood by the profession.

Let’s start by very basic Quantity Theory of Money. The QTM is described by equation



M represents money supply

V represents velocity of money

P represents the price level

and    Y denotes the aggregate GDP

This equation is an identity, which is bound to hold.

Usually V is assumed fixed and assume that in the short run Y is also fixed, and if M is increased, P must also increase so that the equality holds. Therefore the equation says, if money supply in an economy is increased, the price level P will also increase. But this conclusion is based on two assumptions: Constancy of velocity of money and constancy of the aggregate economic activity. Suppose new money is printed and is used to create entirely new economic activity, this means Y is increased. In this case, the equality may hold without increase in price level. The QTM doesn’t predict a necessary rise in prices.

This simple analysis indicates money can be created for new economic activity without fear of inflation. There are the countries opted to print money for new activities and did it successfully without inflation.  

Similarly at the times of economic recessions, people tend to consume less, therefore V decreases. This decrease in V may lead to decrease in Y or P, i.e. to a recession or a deflation. Both deflation and recession are considered undesirable.

Alternatively governments may choose to increase M so that the downward changes in P and Y can be stopped. In this case, the money creation needs not to be inflationary.

This is also evident from the behavior of a large number of developed and some developing nations.

For example, UK had a budget deficit amounting to about 17%  of GDP in Year 2000 . This is because of huge covid related spending and loss of productivity in the first half of 2020. UK financed this deficit by using its central bank. During the year 2020, the money supply in UK increased by about 12% but the inflation actually reduced from 1.7% to 0.4%. Germany spent about 35% of GDP on covid related spending leading to huge increase in public debt and the budget deficit. But inflation in Germany is not out of control. The money supply M2 increased by about 20% in Canada during 2020, without sparking a high inflation. 

The international financial institutions such as IMF have observed that at least during the economic recessions, the central bank borrowing and other kinds of monetary expansions do not bring inflation. Despite this, these institutions use their influence on the developing nations who are obliged to them to enforce the policies that only add to the miseries. 

What is needed at this time is a deeper analysis of relationship between central bank borrowing and inflation. Don’t print money in an uncontrolled manner, but do learn lessons from countries that printed successfully without inflation and try to follow it. Ultimately, the government surplus is people’s deficit and the vice versa

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1 thought on “Central Bank Borrowing and Inflation: between Myth and Reality”

  1. Informative discussion Prof. Atiq, so balancing the two equations sides, ideally by increasing Y with M, would create inflation-free funds for the government to support relief and support packages.

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