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)
However, it provides a rough explanation why printing money reduces the value of money causing prices to increase.
10 comments ↓
[...] Printing more money will cause inflation. [...]
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
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.
[...] started it? The Japanese actually. And then the Yanks did it. So.. tried and tested: it must be ok. No? This entry was posted on Thursday, March 5th, 2009 at 23:43and is filed under Tog blog, Words. [...]
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?
not understandable
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.
this web site is very beneficial for students of economics and finanace as well.
hi ,amazing really
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?
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