Rethinking Central Banking: The Role of the Central Bank Under Modern Monetary Theory
Inflation, Independence, and the Future of Central Banking in an MMT World
Introduction:
Modern Monetary Theory (MMT) challenges many longstanding assumptions in economics, especially regarding how governments spend and how central banks operate. At the heart of this challenge is a rethinking of the relationship between fiscal policy (government spending and taxation) and monetary policy (central banking and interest rates). Under MMT, the central bank is not the independent inflation-fighter of orthodox economic models—but rather a key operational arm of a currency-issuing government.
The Central Bank as an Operational Tool
In the MMT framework, the central bank's primary function is to support the government’s capacity to spend. It does this by creating money electronically on behalf of the sovereign. For example, the Bank of England can add pounds to the economy with a few keystrokes. When the government spends, this money is injected into the economy—facilitated by the central bank but authorized by the government. This reverses the traditional notion that the government must "raise money" first through taxes or borrowing before it can spend.
Challenging the Conventional Narrative
Traditionally, central banks are depicted as neutral and independent actors whose job is to curb inflation by adjusting interest rates and controlling money supply. They are also framed as a check against excessive government spending. But MMT calls this into question. If a government issues its own sovereign currency, MMT argues, it doesn’t need to "borrow" that money from the public or markets in the traditional sense. The central bank is not a watchdog over government finances but an enabler of public purpose spending.
Fiscal Policy Takes Center Stage
One of MMT’s boldest claims is that fiscal policy—not monetary policy—should be the primary tool for managing economic performance. That means spending, taxation, and direct job creation take precedence over interest rate manipulation. In this view, the central bank still plays an important role, but it operates within a fiscal-first framework. Interest rates and liquidity management become secondary to broader macroeconomic goals like full employment, economic equity, and climate mitigation.
A Real-World Example: The Fed in 2020
This shift isn’t just theoretical. In 2020, the U.S. Federal Reserve purchased nearly $1.6 trillion in newly issued government debt, amounting to nearly half of all new Treasury issuance that year. While orthodox economists might view this as dangerous "debt monetization," MMT proponents see it as evidence that the Fed was acting in concert with fiscal authorities to stabilize the economy during a crisis. The Fed’s purchases kept bond yields low, supported asset prices, and provided liquidity—all outcomes aligned with MMT’s view of coordinated fiscal and monetary policy.
Risks and Criticisms: Inflation and Market Signals
Of course, such coordination is not without risks. Critics argue that too much central bank accommodation of government spending could spark inflation or weaken the currency. Rising gold prices and a falling dollar during such episodes are cited as early warning signs. MMT acknowledges this risk but insists the solution isn’t austerity or higher interest rates—it’s smarter, targeted fiscal policy and real resource management.
Conclusion: A New Role for Central Banks?
Modern Monetary Theory reimagines the central bank not as an autonomous regulator, but as a crucial part of a government’s economic toolkit. Its primary mission shifts from defending inflation targets to enabling the broader goals of fiscal policy. While this may challenge decades of economic orthodoxy, real-world events suggest that the line between monetary and fiscal policy is already blurring—and MMT offers a coherent framework for understanding this new reality.