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?

Summary

hyperinflation
Money becomes worthless if too much is printed.

If the Money Supply increases faster than real output then inflation will occur.

If you print more money, the amount of goods doesn’t change. If there is more money chasing the same amount of goods, firms will just put up prices.

The Quantity Theory of Money

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 we assume V and Y are constant in short-term, then increasing money supply will lead to increase in price level.

Simple example to explain why printing money causes inflation

  • 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%.

Printing money and devaluation

If a country prints money and causes inflation, then, ceteris paribus, the currency will devalue against other currencies.

Germany_Hyperinflation
Based on the values in Table IV (page 441) of The Based on ‘Economics of Inflation’ by Costantino Bresciani-Turroni, published 1937. Source: wikipedia

For example, the hyperinflation in Germany of 1922-23, caused the German D-Mark to devalue against the currencies who didn’t have inflation. The reason, is that with the German currency buying less goods, you need more German D-Marks to buy the same quantity of US goods.

Examples of inflation caused by excess supply of money

bank notes
Bank notes in Germany 1923 at height of hyperinflation.ADN-ZB (Aufnahme: Oktober 1923)

US Confederacy 1961-64. During the Civil War, the confederacy printed more paper money. In May 1861, they printed $20 million notes. By the end of 1864 the amount of notes printed had increased to $1 billion. It caused an inflation rate of 700% by April 1964. By the end of the Civil War, the inflation rate was hitting over 5,000% as people lost confidence in the currency.[“Inflation in US confederacy:. Encyclopedia.com]

Germany 1922-23. In 1921 one dollar was worth 90 Marks. By November 1923, the US dollar was worth 4,210,500,000,000 German marks – reflecting the hyperinflation and loss in value of the German currency.

Link between money supply and inflation in the real world

The above anaylsis is something of 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 thoughts on “Why Printing Money Causes Inflation

  1. “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!?

  2. 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?

    1. 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. 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.

  4. 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. 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

    1. 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. 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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