Reader’s Question: Why does printing money cause inflation? Does this always occur?
- If the money supply increases faster than output then, ceteris paribus, inflation will occur.
- If a government prints extra money, households will have more cash and more money to spend on goods. But, if the amount of goods stays the same, the extra cash will just cause firms to put up prices.
Explanation of why printing money causes inflation
- Suppose the economy produces 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 (10,000/1000) = $10
- Suppose then that the government prints 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.
- Ceteris paribus, 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 fewer goods than previously.
Therefore, if the money supply is increased, but, the output stays the same, everything will just become more expensive. The increase in national income will be purely monetary (nominal)
If output increases by 5% and the money supply increases by 7%. Then inflation will be roughly 2%.
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 the short-term, then increasing the money supply will lead to an increase in the price level.
Printing money and devaluation
If a country prints money and causes inflation, then, ceteris paribus, the currency will devalue against other currencies.
- For example, the hyperinflation in Germany of 1922-23, caused the German D-Mark to devalue against the currencies that didn’t have inflation.
- The reason is that with the German currency buying fewer goods, you need more German D-Marks to buy the same quantity of US goods.
Examples of inflation caused by excess supply of money
- US Confederacy 1861-64. 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 1864. 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.
Evaluation – Link between money supply and inflation in the real world
- It is possible, that if the government printed money, people could just decide to save the extra money and therefore, prices wouldn’t automatically rise.
- It is also possible that increasing the money supply could stimulate more output. For example, in a recession, there is unemployment of resources and a lack of demand. If a government prints more money and households start spending more, this may encourage firms to start increasing output and investing in future capacity, which helps to cause an increase in real output. Therefore, the link between increasing money supply and inflation will be weaker.
- Also 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, the above provides a rough explanation why printing money usually reduces the value of money causing prices to increase.