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Through open market operations, the central bank may buy government debt to increase the money supply. Does the government need to pay interest on the debt held by the central bank, or does the debt become interest-free?

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Yes, the government has to pay interest on debt even if it is held by the central bank. That is true at least for major modern central banks.

For example, from a press release from the US Federal Reserve Board:

Net income for 2020 was derived primarily from $100 billion in interest income on securities acquired through open market operations...

However, although modern central banks are in their decision making independent from the government, they are still public entities (or equivalent to such), and profits (if there are any) will ultimately be transferred back to the government. So, to the extent that profits are due to the holding of government debt, the government will get a rebate on interest paid.

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  • $\begingroup$ So the net effect is that no interest is paid? $\endgroup$
    – user253751
    Aug 16 at 12:03
  • $\begingroup$ No, not necessarily. It depends on other central bank activities and the monetary stance. And, of course, central banks have costs, too. For example, if yields are low (as the is the case at the moment), but a central bank were to hold only moderate amounts of debt, profit may be lower compared with a situation where yields are higher and the same amount of debt is hold (assuming costs are unchanged). The net effect varies: it could be that the government gets back less or more than it paid in interest. $\endgroup$
    – BrsG
    Aug 16 at 12:46
  • $\begingroup$ Having said that, it would be interesting to see what the net effect is over long stretches of time (I haven't looked into that). $\endgroup$
    – BrsG
    Aug 16 at 12:47
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    $\begingroup$ This answer is not really true for the UK. While the UK government does technically pay interest to the Bank of England for the gilts it holds, the Bank then gives the interest payments straight back to the government. bbc.co.uk/news/business-20268679 $\endgroup$
    – Mike Scott
    Aug 16 at 20:38
  • $\begingroup$ @MikeScott: The article does not imply that as a rule, it refers to a one off case. From the article: "In future, any additional interest payments received by the Bank will be handed back to the Treasury at the end of each quarter, after deducting the Bank's own cost of borrowing... "(emphasis mine). And: "...the Treasury may well end up having to repay the cash, and more, in future." $\endgroup$
    – BrsG
    Aug 17 at 8:17
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This may vary from country to country, but in most countries government pays interest de jure but not de facto as all major central banks send their profits (including profits made from interest payments) back to their governments as they are government institutions.

For example, take Fed. US has to, de jure, pay Fed interest on its bonds.

However, de facto the debt is free because Fed just sends all it's net profits to the US government. For example, in 2020 Fed sent all its 88.5 billion profits to the US government and it does so each year (see WSJ).

This is an equivalent of government setting up an organization with independent budget, purchasing something from that organization, but then forcing the government controlled organization to sent its profits back to the government. The books of government and central banks are kept separate, but de facto Fed is US controlled institution so if Fed makes profit US government takes that profit and if Fed purchases debt from US government, it is de facto US government funding itself and sending itself back interest payments.

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  • $\begingroup$ Thanks for a decent answer, 1muflon1, I learnt more about de facto and de jure. I am curious about what is the purpose of having separate books while the government just pays the debt and this amount of money goes back to the government? It may cause unnecessary waste of operation. $\endgroup$
    – Louise
    Aug 16 at 10:43
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    $\begingroup$ @NoviceMindset that is a good question. First, accounting across most government entities is kept separately, local police force will have its own accounting books in most countries. This is because it is simply easier to manage large organization by delegation and if you are responsible for some organization, like some police station you dont need to see all the books of the government you just need the local accounting. In addition all these transactions are easy and cheap to execute so its not like this is causing any non-trivial financial cost to the government. $\endgroup$
    – 1muflon1
    Aug 16 at 10:46
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    $\begingroup$ Also the reason why government pays for that debt is because while central banks are government institutions they are kept independent and this is part of the whole institutional set up that keeps them apart. Technically central bank could instead of buying up government debt just send that money to the treasury, but that would tie them more closely together, and since one of the ways how central bank destroys money is by rebuying government debt it would also hamper the central banks ability to reduce money supply slightly $\endgroup$
    – 1muflon1
    Aug 16 at 10:49
  • $\begingroup$ Thanks for your detail explanation. I understood all but the part " but that would tie them more closely together ". My understanding here is " them " stands for "central bank" and "treasury", is not it? and why you use the word " but" here. I mean, what is the problem of " tie the central bank and treasury together" $\endgroup$
    – Louise
    Aug 16 at 10:57
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    $\begingroup$ @NoviceMindset research generally shows that central bank independence is good (like having independent courts or police). In order to create independence in situation when gov controls institution you want to erect barriers both formal and informal between parts controlled by politicians and parts controlled by technocrats. Eg, in many advanced countries it is unwritten rule that politicians cannot serve as central bank governors. One of the rules in the US and in many other countries is that central bank cannot even directly purchase bonds from gov that’s why the go via secondary market $\endgroup$
    – 1muflon1
    Aug 16 at 11:32
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The ridiculous part of the whole thing is, if the fed decides to "buy" bonds" and the hold over two trillion of them... they didn't pay a dime for them, they simple increase the bank balance of what ever bank they "bought" them from. But there is no corresponding decrease in anyone's account for the purchase. The fed's increase in a bank account of some other entity, has no offsetting withdrawal elsewhere.

And of course, when the fed receives interest on its bonds they turn it back over to the treasury! So in effect 2 trillion of the bonds pay no interest.

And I'm sure the Fed thinks it could simply not make an issue when the bonds they hold come due for payment. And I predict someday when things get totally out of hand, they will do just that.

They are playing a deadly "shell game of fraud and deceit", running around in meaningless circles, so no one, they think, gets the true picture of what is happening. And part of it is interest rates of .25% for overnight lending of money. In other words it doesn't cost money to borrow money.

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