Why Printing Money Causes Inflation

Readers Question: One way to finance government spending is to print money, but printing more money leads to inflation. How economic theory justify this?

Ceteris Paribus, if Money Supply increases faster than real output then inflation will occur. The Quantity Theory of Money seeks to establish this connection with the formula MV=PY. Where

  • M= Money supply,
  • V= Velocity of circulation (how many times money changes hands)
  • P= Price level
  • Y= National Income (T = number of transactions)

Rather than delving deep into the quantity theory of money. Let’s think about a simple example.

  • Suppose the economy produces a 1,000 units of output.
  • Suppose the money supply (number of notes and coins) = £10,000
  • This means that the average price of the output produced will be £10 (10,000/1000)

Suppose then that the government print an extra £5,000 notes creating a total money supply of £15,000; but, the output of the economy stays at 1,000 units. Effectively, people have more cash, but, the number of goods is the same. Because people have more cash, they are willing to spend more to buy the goods in the economy.

The price of the 1,000 units will increase to £15 (15,000/1000). The price has increased, but, the quantity of output stays the same. People are not better off, and the value of money has decreased; e.g. A £10 note buys less goods than previously.

Therefore, if the money supply is increased, but, output stays the same, everything will just become more expensive. The increase in national income will be purely monetary (nominal)

If output increased by 5%. and the money supply increases by 7%. Then inflation will be roughly 2%.

This is a simplification. For example, in the real world it is hard to measure the money supply (there are many different measures from M0 narrow money to M4 wide money) Also, in a liquidity trap (recession, different printing money may not cause inflation. (see: Why Printing Money doesn’t always cause inflation)

However, this provides a rough explanation why printing money usually reduces the value of money causing prices to increase.

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34 Responses to Why Printing Money Causes Inflation

  1. Chandra B. Gupta March 28, 2011 at 4:36 pm #

    The simple example given to explain how printing more money causes inflation is very good. Hope to be back again soon to look into other topics. Thanks a lot!

  2. John Krehbiel July 9, 2011 at 7:13 pm #

    I thought of an analogy and wondered if I am correct.

    Suppose there is a concert venue that seats 10,000 people. On one day, the Rolling Stones are scheduled to perform there. Tickets are nominally $50, but since the venue is likely to sell out, scalpers buy them up. Lets assume that Rolling Stones fans have lots of disposable income. So prices quickly rise. This represents the economy at full employment with too much money chasing too few goods.

    Now suppose The Fluorescent Leech and Eddie are playing the same venue the following week. I’d love to see them in concert and have no problem paying $50 for the ticket. But the venue will never sell out. Flo and Eddie are just not that popular. If a scalper bought up tickets and tried to raise the price, it doesn’t matter how rich I am, I have no reason to pay more for the ticket. This is analogous to the economy far below capacity. More money in circulation does not increase the price, but instead stimulates more production. (Schedule another group to play with Flo and Eddie to draw in additional fans, for instance.)

    If I am right, then printing money to put people to work when unemployment is very high will put people to work without raising prices very much at all.

    Is that right?

    • Eric October 5, 2011 at 12:45 am #

      Inflation occurs when too much money chases too few goods and services. If you increase the money supply and the amount of goods stay constant, prices increase because of the competition to buy

  3. George Kent July 17, 2011 at 10:25 pm #

    No where is it chiseled in stone that just because, in this example, the government prints another $5,000 the cost of those output units must therefore increase along with it to $15,000. (I have an American keyboard with no pound key so I’m using dollars.)

    That increase of cost/price takes place only in the minds of people. Prices don’t have to go up. Greed alone drives the price. I never went along with my economics professors teaching the old supply/demand scheme. It doesn’t have to happen.

    When I was in business I disproved that notion. For the thirteen years I was in business my price stayed level no matter the demand for my services. When demand fell off I never had a sale nor when it increased I never raised my price per unit. And I didn’t go broke. I got old, retired and closed my business.

    Folks, it doesn’t have to happen. It is only greed which takes place within the human mind that causes money problems.

    • H October 2, 2011 at 7:25 am #

      Very true.

  4. Lee August 3, 2011 at 5:54 am #

    1 Suppose the economy produces a 1,000 units of output.
    2 Suppose the money supply (number of notes and coins) = £10,000
    3 This means that the average price of the output produced will be £10 (10,000/1000)

    Hi, you lost me right at 3. Why does the money supply relate to the price of goods? I am assuming money supply is all the bills in circulation (like in my wallet or in a cash register). Does this equation assume that every bill in circulation is spent on 1 thing?

  5. Hokus Pokus Poof your money's gone September 26, 2011 at 6:28 am #

    From my understanding, Majority of governments don’t print money. They get money priinted for them by the banks. Every government on earth is in debt therefore every piece of currency weather it’s coins, cash, or credit on a computer screen is handed to government entities with interest considering that, that government spends more then it collects from it’s populous. Hence why currently bigger indebted governments are now clamping down on their defecits. Our governments are ultimately just entities like corporations and/or you and I burrowing from the big bad perpetual debt machine. Paying back the world’s debt is ever impossible with the current monetary policies in place. However, there still are country’s in the world that print their own money just like the western world once did…. One of those country’s is China, and this is exactly the reason why China is in a much better position economically then any other country on earth including and especially the USA. We need to as a people clamp down on our governments and demand nationalization of our monetary systems. Without nationalizing monetary systems debt will forever be hanging over our heads and will accumulate ever more so over our children’s.

    , Good be with you and yours

    • Pokman November 23, 2011 at 3:54 am #

      Well said. I hope that one day those well-intentioned, yet delusional occupiers wake up to realize that their governments & central banking policies are the root cause of their economic misfortunes. Perhaps that will be one step closer to a revolution that will make a real change. Our ignorance to truth is our own prison.

  6. Richard Wilson September 17, 2012 at 11:30 pm #

    I would rather the xbox to run out of supply before you (the federal reserve) give authorizatoin to print more notes which aren’t really worth much. I agree with “Looney Tunes,” if every transaction is virtual, where does the paper dollar comes into play. Is it safe to say that the American dollar is a fallacy? If its virtual, it really doesn’t exist.

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