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.
76 thoughts on “Why Printing Money Causes Inflation”
Can you explain this more simply because I don’t understand it that much
If the government prints money and pay the debts without using it in the country That also caused the inflation rate to lower
As in the above example it clearly explaining the value of currency depreciation.
If your country prints a lot of notes then the money supply increase artificially without any production (Exports). therefore against foreign currencies your currency value dropdown.
that means if you have to pay loans by foreign currencies, you need to find foreign currencies. but without income how does forex come into your country?
If you use printed money to buy forex, again and again, the money supply increase & the money value further down.
it is inflation….
How does each household receive the extra cash put in the system? That would mean a wage increase. Or illegal earnings. That’s the bit I don’t get.
I’d love if someone can explain that bit please…
Exactly my question. How can households have more money if Central bank prints money?
Stimulus packages to the people eg in Covid times
QE after the recession of ’08 and Stimulus during COVID sent checks to all Americans. It also extended unemployment benefits and gave $600 extra per week during the Pandemic.
Whatever you got, IRS rebates during QE, or direct checks of $300 then $1200, or $2400 per married couple and an extra $500 per child.
This is the money you got.
Normally if money is printed and supplied by Bank of England to the market. These money first goes to other banks or financial institution as BOE purchases bonds from banks with a certain rate of interest, banks will receive money in exchange. As more money supplied, they may put down interest rate at a very low rate, about 0-1% to encourage households to borrow and increase consumer spending which is one of the components of aggregate demand. The another method is called helicopter money, this is similar to several support schemes taken place during Covid-19, this is when government or chancellor of exchequer may propose schemes, for example furlough scheme, in order to support those who are unemployment, low wage rate and firms by directly giving money to households.
If a country that can print Euro print money to pay off debt in Euros as well so the extra money isn’t circulated, how would this cause inflation?
Just a thought, Govt can control price to control inflation. Govt can put a cap. Please let me know if this can help and if not and used, what cud be the consequences.
Thanks in advance