Central Banks and Government Debt - Are central banks monetizing debt?

Abstract: This paper aims to determine if central banks have been monetizing the government debt. That is the case if a higher government debt is associated with low short-term interest rate. The goal for central banks monetizing debt is to increase inflation, therefore decreasing the size of government debt. Three hypotheses are constructed. Firstly, higher government debt leads to lower short-term interest rates. Further developments are done with respect to the euro zone and the financial crisis. Fixed effects regressions are used to test the hypotheses. Results show no clear signs of central banks monetizing debt. The ECB had lower short-term interest rates when debt was over 90% of GDP after 2008, however it can be explained by a regime change in monetary policy and the increased hedge the euro zone has against consumption risk due to its’ size. Specification of the non-linear relationship debt has with short-term interest rates makes results highly sensitive to specification of the regressions. More research is needed that tests more specifications and remove the effect monetary unions have on interest rates.