How Does Government Monetize its Debt?
Imagine a scenario when there is a budget crisis in your country. It may be a civil war or a pandemic that has destroyed the state’s ability to collect taxes or the aftermath of a war that leaves the government with low tax revenues and high expenditures for reconstruction. Or it might be an adverse economic shock and the government, due to loss of credibility, becomes increasingly unable to borrow either from the public or from abroad. But the government is under an obligation to redeem all those debts it had accumulated earlier.
Now you must be wondering that how will the government redeem it's debt when it has no alternative of borrowing money? Well, the government certainly has one option which people like you and I don't have and that is to create money which is known as monetization of government debt.
Monetization is, broadly speaking, the process of converting something into money. In cases where the government’s debt overshoots expectations sharply, to finance that debt, it can spend the money it already holds. Any government that issues its own currency can continue to create money.
Things could have been otherwise but when the mint is partially in the hands of the government, the tendency to create money is strong. For this, the government can issue bonds and ask the central bank to buy them. The central bank directly purchases government securities and then pays the government with the money it prints and the government uses that money to finance its debt. This process is known as the monetization of government debt.