Direct Monetary Financing, Quantitative Easing and Inflation

As a political economist, I am very glad that monetary policy has finally been added to the game, even if only in a very limited capacity, which is understandable. The most notable limitation, which has been recognised by the developers, is that there is no central bank target interest rate that can be manipulated. I have some suggestions on how to make monetary policy more realistic with very few changes to the current system and without requiring a central bank target interest rate.

Direct Monetary Financing

Add an additional monetary policy option besides Quantitative Easing (QE) and Helicopter Money (HM): Direct Monetary Financing (DMF). DMF means the newly created money is not pumped into asset markets (QE) or given to citizens (HM), but is used to finance public expenditure. In the game this should be reflected in the budget and influence inflation. One could argue about whether it should also boost GDP, but I would suggest DMF does not do so directly. It can instead do so only indirectly, through the policies that can be financed with it.

It is odd that it is currently possible to hand out money to citizens, but not to use it for public spending.

Quantitative Easing and interest on government debt

QE and similar programs of asset purchases have the effect of lowering the interest rates governments pay on their debt, which is currently not modelled in the game. This is because these programs often include buying of government bonds, which pushes up their price and thus lowers yields, i.e. interest paid by the government. This should be simple enough to fix: just make it so that QE reduces interest rate paid on debt. I think doing this would also to some extent make up for the lack of a central bank target interest rate (for reasons I won’t go into, basically central banks regulate real interest rates towards target interest rate also through asset purchases and sales, so it’s not dissimilar in terms of effect).

Inflation

The developers have recognised that central banks target some inflation (usually around 2%) because too low inflation or even deflation is bad (people hold onto their money instead of spending it). So when inflation is low, expansionary monetary policy (QE, HM, DMF) can be used to counteract this.

What is, as far as I know, currently missing from the game, is that this is often specifically necessary during economic downturns, which can lead to deflation, in the worst case a deflationary death spiral, unless acted against using expansionary monetary policy. I thus suggest that inflation is somehow linked to the business cycle. For example it could be linked to employment, as suggested by the Philips curve, i.e. low employment -> deflation, high employment -> inflation. Perhaps this is already the case, then just ignore this last point.

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