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.