Readers Question: would you please explain to me how we can have no inflation, or low inflation if the government injects two or three trillion dollars in the US economy and output falls?
This is an interesting question. But, you can print money without causing inflation in some circumstances.
In short, the reason is that in a depression, even though the money supply increases, firms and consumers don’t go out and spend it. They save it, pay off debts, use it to meet a fall in income. Therefore, although the supply of money is increased, the amount of money circulating around the economy is still falling.
What counts is not just the amount of money (i.e. how many $10 bills you have), but how often it is used. In normal times, if you gave every citizen $1,000 they would go out and buy more luxuries – this could be inflationary. But, in this circumstance, if you gave households $1,000 there would be no surge in demand – many households will lose much more than $1,000. Other households with good income will probably save extra income for now.
Often quantitative easing involves the Central Bank printing more money and buy bonds from private banks. But, what will commercial banks do with this increase in money?
They will not lend it to business or consumers. Nobody wants to invest or spend at the moment. They will just increase their cash reserves, so although there is more money in the economy, economic activity is still in decline.
Why printing money usually causes inflation
In normal circumstance (e.g. no shut down, most people employed) if you print more money and the number of goods remains the same, we will get higher prices.
- Because consumers have more money they want to buy more goods.
- Firms see a rise in demand and so put up prices to ration demand.
- The number of goods remains the same, they are just more expensive.
This seems quite logical but, the difference is that economic circumstances are now very different/
More detail on why printing money might not cause inflation
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)
- If the Central Bank pursues quantitative easing, Money Supply (M) increases
- If V (velocity of circulation) and Y (output) stayed constant, Price level (P) would increase.
- However, V (velocity of circulation is falling). – Instead of going out to the shops, people are staying in.
Another way of thinking about this question is why inflation is very unlikely when output is falling 20% (record level of GDP fall)
Why inflation is very unlikely due to Corona shock
We are experiencing a supply-side shock. If people can’t work due to self-isolation, aggregate supply (AS) will shift to the left. This could be a little inflationary, e.g. if the supply of food is disrupted (because we can’t get people to pick food), this will push up food prices.
However, any supply-side shock is likely to be limited by the drastic fall in oil prices. The fall in oil prices is shifting AS to the right – we will get lower prices of transport, fuel.
Overall, what is happening to the economy is something like this
- Small fall in aggregate supply (factories closing down)
- Large fall in aggregate demand (fall in investment, fall in consumer spending, fall in exports.
Also, although there may be a small supply-side shock, there is a much bigger fall in aggregate demand.
This might cause deflation.
In this situation, if you printed money and gave to households, the fall in AD may be less severe – rather than 20% fall, we might get 15% fall, so printing money may limit the scope of deflation.