Definition of monetisation
Monetisation refers to the conversion of an object into money, which means that it is generally accepted as a medium of exchange. Metals are monetised as coins once they are standardised in weight and accepted as money.
Government debt can also be monetised, which occurs when a government replaces its interest-bearing debt with money.
Here is how the process of debt monetisation works.
When a government spends in excess of its tax revenue it must borrow from the public. The public purchases this debt because it pays an attractive interest rate. If the government has a significant amount of debt outstanding, it may choose to purchase its own debt with newly printed currency. The government has thereby replaced its interest-bearing debt with money, and has thus monetised part of its debt.
Inflation is an unfortunate consequence of debt monetisation. The public was willing to hold the government’s debt as part of its investment portfolio because the debt paid an attractive interest rate, but the same is not true for the newly printed money.
A consequence of purchasing debt with money is that now the supply of money exceeds its demand. An attempt to purchase goods and assets with this excess money supply will drive up prices, thus generating inflation. Indeed, debt monetisation to finance a deficit is referred to as inflationary financing of the deficit.