Why Printing Money Causes Inflation

Readers Question: Why does printing money cause inflation? Does this always occur?

Summary

hyperinflation
Money becomes worthless if too much is printed.

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

If you print more money, the amount of goods doesn’t change. However, if you print money, households will have more cash and more money to spend on goods. 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 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.

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.

money-supply-inflation-link

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 increased by 5%. and the money supply increases by 7%. Then inflation will be roughly 2%.

Assumptions in the above example

[In the real world, it is possible, if the government printed money, people would just decide to save the extra money and therefore, prices wouldn’t automatically rise. However, to simplify the link between the money supply and inflation, let us assume that consumers are willing to spend the extra money. Also, if you expect inflation to rise, you have an incentive to spend it – rather than see the value of your money fall.]

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 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

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

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.

Link between money supply and inflation in the real world

The above analysis 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

By on October 1st, 2017

47 thoughts on “Why Printing Money Causes Inflation

  1. I agree with Dan. The article said that if the government prints more money, then “…Effectively people have more cash…” That suggests that when the government prints more fiat money, then “people” effectively either get a raise in salary, or the price of goods falls. This does not happen of course. (Similarly, why would manufacturers raise prices of their products just because the government prints more fiat money? Or does some other “entity” set the prices of goods?) How can people spend more if they don’t have more? Sure, they can go in debt with credit cards, but debt is not equivalent to “effectively” having more cash”. The average person has no idea whether the government is printing fiat money or not. So, the article must mean something else, but it’s a total enigma to the reader not trained in economics. Economists need to explain specifically who the “people” are that “effectively” have more cash, and what “effectively” means. The article says it’s a “rough” explanation, but it’s a bit too rough I think.

    1. Money is a representation of what the nation as a whole is worth. Printing more money (without destroying older currency) means that the value of the nation is split into even more pieces (ie cutting a pie into 10 pieces means each pie is smaller and worth less than if it were cut into 4 pieces, even though you still get 1 “slice”)….So, yes. Printing more money means we (the “people”) get more money in our pockets. Unfortunately though, it also means that the money in our pockets is now worth slightly less, requiring us to carry MORE of it around in order to do what we did BEFORE they printed more money (kind of like how things cost less when you were a kid than they do now as an adult.).

  2. What would cause inflation in a third world country where most of the people are poor and a few have gained tremendous wealth through corruption and looting

    1. In situations like what you’re describing the value of money would either deflate ($1 now being worth say $1.50 since there’s less of it in circulation), or would become worthless since there isn’t enough in circulation to make the currency a viable means of exchange. This is why (or at least partially why) so many “3rd world countries” have currency values that are so low. Remember…the point of money is to facilitate trade…If there’s no trade being carried out in a given currency, that currency looses its value.

      To answer your question though, for there to be inflation in that type of scenario would require something (drought, flood, fire, destruction, etc) to destroy the available items with which to spend money on. In this case, having fewer items to purchase makes them more rare and hard to come by, and as such require more money to obtain which has the end effect of creating inflation.

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