Module 14 · How the economy works
Why not print money? QE and the lender of last resort
Why printing money to pay bills raises prices, what EU law forbids, how quantitative easing differs, and when a central bank may lend to a bank in a panic.
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In this lesson
- Explain with the quantity equation why printing money to pay for everything raises prices
- State the EU rule against central banks financing governments directly
- Describe quantitative easing and tightening, and why bond prices and yields move in opposite directions
- Explain the lender of last resort and why it lends only to solvent banks
The mayor of a small town says: “We need €10 million for a new school. The central bank has a printing press. Why does it not print the money?” The question sounds sensible. Here is why it is not.
Printing money to pay bills raises prices
Money is a claim on goods and services. If the amount of money doubles but the town still bakes the same loaves, builds the same cars and cuts the same hair, sellers can raise their prices. Each euro then buys less.
A simple identity shows the logic: M × V = P × Y. Money (M) times how often it is spent (V) equals the price level (P) times real output (Y).
In normal times the link between money and prices is loose. In extreme cases it is strong: the lesson shows Germany in 1923, Yugoslavia in 1993 and Zimbabwe in 2008. Printing also hurts savers and people on fixed incomes most, so it is sometimes called an “inflation tax”.
What EU law says
Article 123 of the EU Treaty forbids the ECB and national central banks from giving governments overdrafts or other credit. They also may not buy government debt directly from the state. This is . The aim is to push governments towards sound budgets. So the Slovenian government cannot ask Banka Slovenije for a loan. It borrows from investors, by selling bonds.
QE and QT
When short-term rates are already near zero, a central bank can still ease conditions by buying bonds. This is (QE). It buys government and some other bonds from investors on the market. The purchases push bond prices up and long-term rates down, and add reserves to the banking system. (QT) is the reverse: the central bank lets its bonds mature without replacing them.
QE is not a gift to the government. The money goes to the investors who sell, the state still owes the debt, and the purchases can be reversed.
The ECB began buying government bonds on the market in March 2015. In March 2020 it added the pandemic emergency purchase programme (PEPP), with a limit of €1,850 billion. Net purchases ended in 2022. The ECB then stopped reinvesting maturing bonds, from July 2023 for the older programme and from the end of 2024 for PEPP. Euro area inflation stayed below 2% in every year from 2015 to 2019.
The lender of last resort
In a panic, even a healthy bank can run short of cash if many depositors leave at once. The idea of a goes back to Walter Bagehot in 1873: the central bank lends freely, against good collateral, at a penalty rate. In the euro area this is called emergency liquidity assistance. It is provided by the national central bank, under ECB oversight, and only to banks that are solvent.
A bank whose losses exceed its capital is insolvent. Lending to it would be monetary financing. It is dealt with by resolution, the topic of a later lesson.
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