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.

Related

34 Responses to Why Printing Money Causes Inflation

  1. jayms November 19, 2008 at 4:01 pm #

    supposing a government printed more money but only used to to finance the cost of imported goods, what then would be the effect on the domestic economy? supposing the price of these imported goods was the same as before the extra money was printed, there is just a larger quantity of them now.

    also same question but exchanging spending on imports with general government spending ie on defense etc. if the public doesnt see the direct effect of this extra printed money how can inflation occur, all they will see is more missiles etc…..

    this has always confused me, any responses would be greatly appreciated
    great article by the way
    thanks
    j

  2. Business Coaching Phoenix November 20, 2008 at 11:34 pm #

    Given that most things are falling in price and value now, it makes sense to infuse the domestic market with dollars because there is little risk that the negative affects of inflation are going to override the need for Americans to have cash to spend. I’m thinking a $10,000 to $25,000 rebate for every taxpayer making less than $100, 000 per year is a good start.

  3. Neil March 15, 2009 at 9:39 pm #

    What if increase in money supply ( printing money) is done to accomodate an existing hole of debt. For example the Fed printing money to pour into the debt created by synthetic motgage products? Surely then effectively the money supply was increased in the the past- diriving inflation historically, and now the money supply only mitigates the effect of the lack of supply?

  4. vikas May 3, 2009 at 2:38 pm #

    not understandable

  5. RSleepy September 29, 2009 at 5:44 am #

    Thanks very much for explaining this. I thought I must be dumb to even wonder about it, but the very intelligent questions show it to be more complex than I realised. I think many people just take this for granted without thinking it through. Thank you.

  6. HASNAIN November 17, 2009 at 12:52 pm #

    this web site is very beneficial for students of economics and finanace as well.

  7. samreen January 17, 2010 at 3:09 pm #

    hi ,amazing really

  8. samreen January 17, 2010 at 4:36 pm #

    but my question is ,sometimes it can also be happened that government print money just to start the new developmental projects.or to pay off the debt.then in such situation how it cause inflation?

  9. Bir May 22, 2010 at 9:30 am #

    Is there any thing that limits printing of money by the central bank .If a economy is in extreme debt status, why cant it print more money and pay off debts , how would this impact inflation. Debt servicing by tax policies reduces income of households ,it somewhat has similar effect as inflation. i.e less income and lower purchasing ability.can any throw light on this

    • john February 21, 2013 at 10:27 pm #

      because the banks are the only entity that can print the currency in the united states. they only print the money when the government gives them bonds, thus making the money debt. it is created out of virtually nothing. however there is interest attached to the debt, and it perpetuates a endless cycle of borrow, pay back, borrow, pay back, and while that is going on, the overall debt is rising. the only way to pay back the debt, is to add more debt.

  10. Tom Mortensen August 17, 2010 at 3:37 pm #

    I am still puzzled by one aspect of this process. After
    the government prints the money how does it, in practical terms, get into the hands of the spending
    public.

  11. Looney Tunes September 16, 2010 at 3:02 am #

    I fail to see how more printing needs to be done when we live in a 95% CASHLESS SOCIETY !!!

    Most transactions done (that matter) are done via electronic means… (ie. Credit Card, EFTPOS, T/T). Even Cheques are NOT cash.

    And people don’t eat Cash, they spend it. So that means much of the cash that is out there, gets recycled back to the banks and when they are ripped or damaged or just plain past expiry date… And of course, more money needs to be printed to replace that. Are they considering the cash that was returned?
    What if cash is printed in indestructable plastic and doesn’t need to be replaced every so often, only every 10 years… would that mean that inflation would increase every 10 years? Because in a CASHLESS society, I fail to see how cash has any relevance in inflation… You could have used this excuse 20 years ago but now since most transactions are electronic, it just doesn’t stack up!

    Really, this is just an excuse to increase inflation… higher inflation, government gets more money from tax. Higher price = more tax. Simple calc and an easy excuse to put over most of the people that aren’t thinking.

    • economics_enthusiast April 3, 2012 at 10:29 am #

      You’re completely right about the fact that many of our transactions are no longer done with actual cash, but instead using bank accounts. However, to increase the supply of money in the economy the government does not necessarily have to print more. Nowadays, they can simply add money to the account, and this does not require such a massive waste of paper.

  12. amoo November 20, 2010 at 12:50 pm #

    How do evaluate the decision taken by Obama Administration to print 600 billion dollar on a small open economies

  13. Kitster December 7, 2010 at 11:04 pm #

    If you take a 1 Dollar amount of Gold, and a 1 Dollar note, then you have equality. The paper money is really only a promisory note for said value. The Gold is used to back those notes.

    If you have 1000 Dollars worth of Gold, then you can have 1000 Dollars in promisory notes, to spend.

    Take 1 Dollar worth of the Gold, and one 1-Dollar note. If you then print another 1 Dollar note, for the same piece of Gold, you now have a 1 Dollar piece of Gold, but 2 notes now worth only a Half-Dollar each.

    You have reduced the value of the Dollar notes against the Gold Standard.

    But, since the value of itemms is based on the value of the Gold, your 1 Dollar loaf of bread now has to cost 2 Dollars.

    That’s how printing more money affects inflation.

    If you just use it for imported goods, the cost of those goods goes up. Same for military or government spending – the source material has to come from Somewhere, so somebody would get shorted.

    Printing fresh money is not a fix for a troubled economy. It just makes it worse.

    • john February 21, 2013 at 10:25 pm #

      we are not on a gold standard.

  14. Joe December 16, 2010 at 1:00 am #

    Printing money does not cause inflation.

    http://research.stlouisfed.org/fred2/graph/fredgraph.png

    As you can see printing money and inflation are completely independent and show zero correlation.

    It’s just a gimmick to keep people from talking about the real issue. Massive accumulation of wealth in the hands of the elite rich. The far right have completely hijacked our government.

  15. Andy-Laa March 23, 2011 at 1:23 am #

    “Because people have more cash, they are willing to spend more to buy the goods in the economy.”

    No they aren’t!

    I just don’t get who finds out “Oh shit there’s more notes in circulation now” and so…tells(?) the shopkeepers to start charging more/the suppliers to the shopkeepers/etc etc…it doesn’t make logical sense to me.

    Basically, why do some people have to have less money than others for an economy to work!?

  16. 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!

  17. 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

  18. 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.

  19. 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?

  20. 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.

  21. 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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