Effect of Printing Money on Economy

Printing Money creates a sense of nervousness amongst both economists and the general public. It immediately conjures up memories of hyper inflation in Weimar Germany in 1923 and Zimbabwe in more recent times.

If a government prints money faster than the growth of real output it reduces the value of money and this invariably causes inflation. Governments often resort to printing money when they cannot finance their borrowing by selling bonds. This hyperinflation can be extremely damaging to an economy.

Printing Money and Quantitative Easing

Despite the possible threat of inflation, governments in Japan, US and now UK have resorted to using quantitative easing (a form of printing money) to deal with deep recessions and the prospect of deflation.

In a very serious recession, demand falls so much that it is possible to increase money supply without creating inflationary pressure. (If we consider quantity theory of money MV=PT. V, the  Velocity of circulation falls in recession, so we may need to increase money supply just to avoid deflation) So usually printing money causes inflation. But, in periods of falling velocity of circulation (number of times money changes hands), printing money doesn’t necessarily cause inflation. The credit crunch has caused a fall in the velocity of circulation.

How Does Quantitative Easing Work?

There are different forms of quantitative easing. But one form is where.

  1. The Central Bank creates reserves. This is creating money electronically. Basically, the Bank just decides to inflate its cash reserves by say £50bn.
  2. With this extra cash the Central Bank will buy a range of government gilts and private sector assets such as corporate bonds.
  3. Private banks sell their assets to the Central Bank and see an increase in their cash reserves. With these cash reserves they should be more willing to lend money.
  4. By buying government bonds, the Central Bank increases the value of bonds pushing long term interest rates down. This fall in long term interest rates also has a reflationary effect.

Does Quantitative Easing Work?

Some say Japan’s period of stagflation would have been worse without quantitative easing. But, it is early to say for US and UK.

Quantitative easing is risky. One issue is whether the Central Bank can remove the excess liquidity when the economy recovers.

Why Risk Printing Money when it could cause inflation?

The prospect of deflation is much worse than inflation. Deflation could make a minor recession into a prolonged depression. Deflation is very damaging to the economy because it discourages spending and increases the burden of debt.

Printing Money and effect on Exchange Rate.

Printing money reduces the value of your currency. Inflation reduces the value of domestic securities making international investors leave the economy. (printing money and effect on exchange rate)

Further Reading

4 Responses to Effect of Printing Money on Economy

  1. Ralph Musgrave March 7, 2009 at 8:52 am #

    The above is a good summary of quantitative easing. But I disagree on the following points.

    It is claimed above that “If a government prints money faster than the growth of real output it reduces the value of money and this invariably causes inflation.” The word “invariably” is too strong. Printing money does not necessarily cause inflation: the initial effect is to boost demand. If demand is boosted by just enough to escape the recession, but not by so much as to cause excessive demand, then with a bit of luck, no inflation would ensue. The US monetary base has DOUBLED in the last quarter. This is unprecedented, but no one is expecting rampant inflation in the US any time soon.

    The third para above refers to “ quantitative easing (a form of printing money)”. Q.E. does not necessarily involve printing money. The Bank of England a month or so ago announced that it intended starting on Q.E. quite soon, but that it would initially sterilise any money supply increase by selling gilts. They said that a month or two down the road they would think above ceasing to sterilise if it looked as though the economy needed a stronger boost.

    “In a very serious recession, demand falls so much that it is possible to increase money supply without creating deflationary pressure.” The word “deflationary” should be “inflationary” should it not?

  2. Kris March 31, 2011 at 1:40 pm #

    How can you measure QE?

Trackbacks/Pingbacks

  1. How Long Will Interest Rates Stay Low? | Finance Blog - March 10, 2009

    [...] The effects of quantitative easing on inflation is hard to quantify. Traditional analysis (in normal times) suggests printing money causes inflation. This link is not as simple though. With falling velocity of circulation, it is possible to increase money supply without inflation. For more details see: effect of printing money on economy [...]

  2. Creating Money Electronically | Economics Blog - October 5, 2011

    [...] and avoid deflationary traps. The concern is that increasing money supply could lead to inflation (printing money and inflation) However, evidence from the 2009-10 experiment of quantitative easing is that when the Central Bank [...]

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