Readers Question: And I was wondering why does the government need to borrow money during a Recession, instead of simply printing more money? (from Govt Borrowing in recessions)
The quantity theory of money MV=PY suggests that if we increase the money supply faster than National Output grows, we will get inflation. Therefore, if we have zero growth and the government increases the money supply by 5%, then in theory, we will get inflation of 5%.
In practise the link between money supply and inflation is more complex. But, the general principle is that printing money doesn’t create wealth or output, it just increases the money supply. Therefore, the value of money decreases and Real Output doesn’t increase (Real Output = Nominal output – inflation)
By borrowing money, the government is able to inject spending into the economy. E.g. they borrow from the private sector and build a new roads. This directly creates jobs and employs previously unemployed resources. This government spending may also create a multiplier effect, where an initial injection into the economy causes a bigger final increase.
The exception to this rule is when an economy has a recession and deflation (prices fall). If an economy has deflation, then the Central banks should be printing money. They should print money to get rid of the deflation and maintain a moderate inflation expectations. (Most central banks aim to target inflation of 2%) Deflation tends to cause lower spending and lower growth. Most economists agree a small amount of inflation is less damaging than deflation.
See also: Printing Money