The Fed creates and then lends money to the US government – will this spur growth or inflation?

Editor’s Note: Dr. Mike Walden is Distinguished Reynolds Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University. He teaches and writes on personal finance, economic outlook and public policy.

RALEIGH – Although the main principles of economics were established decades ago, the discipline is constantly evolving. One of the most recent contributions has been a new field called “behavioral economics”. Here, the researchers developed ideas as to why, in some cases, individuals seem to be going against their own best interests in making choices. I have found the knowledge of behavioral economics to be extremely useful. Apparently, the same is true of the profession of economist, as several leaders in the field have won Nobel Prizes in recent years.

There has been another new development in economics that focuses on decisions impacting the big economy – or “macro” – rather than the individual economy – or “micro”. The new development is called “modern monetary theory”, or MMT. I’m sure the creators of MMT hope it will be as successful as behavioral economics. And they might not have to wait long because a big MMT test could be approaching.

Dr Mike Walden

MMT primarily focuses on federal debt. Traditional economic theory states that the federal government can pay for its expenses in three ways. It can tax household and business income to finance spending. Or, he can borrow money from private sources to pay for his expenses. Finally, the federal government can borrow funds from the country’s central bank, the Federal Reserve.

With the first method, the costs of the expenses are immediately paid by the taxpayers. When you borrow from private sources, there are two costs. The first is regular interest payments on loans, and the second is the payment of principal (the amount borrowed) at the end of the loan term, unless the loan is refinanced.

With the third method – borrowing from the Federal Reserve – there is a unique aspect. When you or I pay taxes, we send the money we have earned to the government. Likewise, if we are prepared to lend money to the federal government because we want to include federal investments, called treasury securities, in our investment portfolio, we use the money that we have earned again.

The Fed creates money

But when the Federal Reserve lends money to the federal government, it doesn’t use the money the central bank has earned. Instead, the Federal Reserve uses the money it created. That’s right, the Federal Reserve has the unique ability to print money, although in today’s economy creation happens digitally.

In the past, the Federal Reserve was careful about the amount of money it created for fear of triggering faster price increases, i.e. higher inflation. In fact, there has been substantial research in many countries showing a link between faster money creation and higher inflation.

But now enter MMT. MMT questions the hypothesis of an automatic link between money creation and inflation. Specifically, the MMT says that if government spending funded by the newly created money makes the economy more productive – resulting in faster economic growth and more jobs and incomes – then the rate of inflation will not increase. not. In addition, a larger economy will make debt payments more affordable for the federal government.

In short, supporters of MMT see government spending backed by newly created Federal Reserve money as a way to unlock the potential of the economy by investing in projects such as infrastructure, education, and research.

Supply economy

Interestingly, MMT serves the same purpose as another macroeconomic theory, “supply economics” (SSE). Both ideas aim to increase the growth of the economy. But ideas use opposite approaches. MMT uses increased public spending, debt, and money creation to stimulate the economy, while SSE lowers tax rates to motivate more spending and private investment.

The ESS was implemented as recently as 2017, when federal tax rates were cut to revive a sluggish economy. As might be expected, economists differ on the success of the policy.

Now we may be considering a MMT test. Over the past year, the federal government has authorized $ 6 trillion to be spent on fighting Covid-19 and the resulting recession. Of the funds raised to date for these expenses, the majority comes from the Federal Reserve. There are likely to be more proposals ahead for additional federal spending, in areas like infrastructure, energy and climate, student loan cuts and a basic household income. If these proposals come true, and if most of the funding comes from the Federal Reserve, then it will be a big, big test of MMT.

One of the things I love about being a professional economist is that you never get bored. Economists are constantly developing and debating new ideas about how the economy works and can be improved. Modern monetary theory is the last of these ideas. Will MMT work or fail? Soon we might have a test to help us decide!


Troy M. Hoffman