Mr Anonymous in response to my post "Asphyxiation By Forex" wished to know how Governments are going fund their fiscal deficits - Will they borrow the money or just print it?
The answer - bit of both actually. The technical term for Governments printing the money they need is 'Debt Monetization' or 'Quantitative Easing'. It works in the following manner: When the Government can’t find domestic or foreign buyers for its debt (usually because the interest rate is not high enough to attract lenders), the Central Bank buys this debt by printing new money. The government spends this money and in turn debases all the currency outstanding. Essentially the Central Bank "creates" money.
This is a sophistication of a process first used by the Roman empire. They would shave some gold off the edges of gold coins, remelt the shavings and mint them into more coins. The new coins would then be recirculated !!
Coming back to the present, the US Federal Reserve has "created" nearly $1.3 trillion dollars since October 2008. See the chart below:
Source: Wikimedia CommonsIs It Useful?
The size of a nation's economy is the total value of the spending on goods and services in the nation in a year.
The formula for GDP (Gross Domestic Product) is:
GDP = C + I + G + (Ex - Im)
where “C” equals spending by consumers,
“I” equals investment by businesses,
“G” equals government spending and
“(Ex - Im)” equals net exports, that is, the value of exports minus imports. Net exports may be negative.
The Global Economy is in the midst of a severe recession. Demand from consumers and businesses has dropped sharply. Economic theory suggests that the Government should increase spending to cushion the blow. By spending borrowed money Governments are trying to get the economy moving again.
Is there any risk?
The problem created by Quantitative Easing is that more the money in the economy less is its value. So it buys less over time. The prices of goods and services increase .leading to inflation. Inflation s a problem because it lowers the real value of wages and salaries and hurts people like retirees with a fixed source of income whose standard of life reduces due to inflation.To sum up, Quantitative Easing is aimed at increasing the supply of money into the economy. Once the economy shows signs of recovery Central Banks will have to reduce the supply of money. If left unchecked the excess money can lead to high inflation, but managed well will soften the downturn.
1 comment:
Mr. Anonymous thanks you for the easy to understand answer and for making the effort of writing up a new post.
Now I am wondering why, despite the US FED pumping $1.3 trillion into the US economy, the rupee-dollar is at an all time high of almost 50:1. Shouldn't the global availability of these additional paper dollars result in its devaluation vs other currencies? Or is the RBI artificially controlling rupee-dollar rates? Or is it a little more complicated than that?
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