How does printing money cause inflation?

Question

I've had this doubt for a long time and I still can't find a proper answer to it. Most answers I get just partially explain the phenomenon of a general increase in price level. I want to understand WHY and HOW monetary issue causes inflation.

I'm always told that if a country A has a total amount of output of $100 and this amount is represented by 100 coins of gold, then each coin of gold stands for one unit of output. If one day I stumble upon a gold mine and produce 100 further coins of gold, then I'll have 200 coins, so each coin now represents 0.5 units of output. It's is completely obvious that now each monetary unit has a lower purchasing power, but how do suppliers notice this? How does the economy as a whole detect this increase in money? If the answer is an increase in the demand for goods, then why do suppliers raise their prices? Why don't they just keep prices on a the same level if they know inflation is going to destroy us all?

Answer 1

WHY and HOW monetary issue causes inflation.

When a central bank emits money (or decrease key interest rates), commercial banks will be able to refinance themselves at a lower cost. Which means that at the end, these commercial banks will also be more, say, flexible, and thus will stimulate demands (here and there) in the national economy by lending money (here and there). If supplies stay constant, markets will reach a new equilibrium via prices rising due to these stimulated demands $\implies$ inflation.

Answer 2

I feel your question can be rephrased as - "How does mined gold enter into money circulation and what effects does it have level and price of money."

Using your example - M2 and GDP Let's take the example you quoted. I am using M2 to denote money supply and GDP to denote output. In your example, 100 units of Gold is the GDP. Now, these are two different things of course and M2 / GDP ratio varies by country. World average is 125% as checked from World Bank. Source

So, M2 = 125 following from your example. Now, the mined Gold would be sold in the market at world price assuming free trade and no exchange restrictions. If entire world is on the Gold standard, all currencies are pegged to the Gold and they are essentially having 1:1 ratio (doesn't hold true in real life though even when we were on Gold standard; separate topic).

Impact of mined Gold on World Price of Gold So, if the size of economy in your example is very small say less than 1% of Global GDP, then the impact on world prices of additional 100 units of mined Gold will be very less. If on the contrary, the economy is large, it will have a substantial negative impact on price. Price of gold will go down because supply increased substantially.

How does this enter money circulation? When the customer - say a large gold trader or a jeweller or an industrial company(ies) buys the gold, they could either put the Gold in the bank and swap money for it or warehouse it. Former = enters money circulation. Latter = doesn't yet. Whenever the Warehouse gold is sold, it will enter money supply when it is exchanged for bank notes. Some of it might get used for industrial manufacturing and jewellery and that will end up in consumption and not money supply.

Impact of mined Gold on Level and Price of Money Now, whenever this new Gold enters the money circulation, the bank essentially prints new money. This broadens the M2. Depending on the reserve requirements, banks can lend more now and essentially credit goes up, interest rates move down and inflation goes up afterward. GDP would go up depending on the ratio of M2 to GDP as explained above.

Example: if the reserve requirements are 10% then banks can lend up to 100 dollars for each 10 dollars worth of Gold in their vaults. This 10 dollar worth of Gold increases when new Gold is mined.

Answer 3

As mentioned in the comments, I too ran into problems on first attempts to understand inflation as far too many people give what I can only describe as "textbook" answers to the question that fail to help anyone grasp the underlying logic. That being said, I will do my best to explain it in the most simple and concise way I can conceive of.

We start by establishing a barter economy where we have only two items, food and wood.

If there is a particularly good harvest season and we assume that wood is bought with food (food is now the basis for price) and that each producer of wood is looking to take the best price, then it is as simple as understanding that the producers of food now have more resources to barter with, which allows them to bid against each other more competitively and at higher prices. If we track the food-price of wood, we can see that as the supply of food increases (inflates), the food-price of wood increases as well.

If we add a third product, copper, and we say that the producers of copper do not need wood, only food. Then we may begin to consider food a common currency. Its supply is a means of participating in the auction for goods across the entire market.

If we were to have a bad harvest, there is simply less for the producers to come to auction with when they bid on wood or copper, as a consequence the food-price of both these items comes down. Whether they do this with actual food or paper notes that are redeemable in food, the principles are the same. As to why we began to use gold rather than food (which is what we started with), that is an answer to a different question.

If you can understand this, you understand the core concept of inflation. It's just jargon for excess supply and, in school, often used only to describe currency rather than goods. The next step is understanding it in terms of modern Western economies which is notably more complicated.


At its core its the same principle discussed above, except we are dealing with a case where the currency has nothing backing it other than our expectation that other people will accept it AND the knowledge that we are compelled to pay tax and that said tax must be paid in said currency. Its supply is controlled by help-for-profit banks that work closely with national governments (federal reserve in the U.S. ). However, to answer the direct question in the title, how does printing money cause inflation. Think of the example above, just think of it as the added supply to understand it at a very basic level. These help for profit banks add monies to the economies of the world in a number of different ways (quantitative easing, reserve requirements..) and how it affects your local economy is something you can spend an academic career studying.

I won't go into specific central banking mechanics as your description seemed to be better answered by a description of the mechanics of inflation itself. Maybe I misunderstood, if so, comment, otherwise, I hope this helps.

Answer 4

Printing money does not cause inflation. How could it? What matters is whats done with it, not its mere existence. Inflation is caused by demand for goods and services continuously exceeding supply. Eg cost push, when supply is low, eg oil in the 70s, or demand pull , eg in a evonomy that is growing very fast/overheating .

The quantity theory of money says MV=PQ and so some will say this says that an increase in M (=money supply, eg by printing money) will cause an increase in P (price level). However this assumes that V (velocity) and Q (quantity) do not change, which is a prepostorous assumption!

The expression printing money has been used so consistently in the context of weimar germany that it always brings up that feeling but ofcourse the problem in germany then was that there was massive debts in foreign currencies they were forced to pay and massive shortages of goods, (eg due to frances annexation of the Rhineland ) lots of strikes, in general utter pandemonium, meltdown!

Answer 5

If the answer is an increase in the demand for goods, then why suppliers rise prices? Why don't they just keep prices on a the same level if they know inflation is going to destroy us all?

Because that doesn't fix their problem.

Suppliers have a limited amount of goods. In order to get more goods, they have to purchase the inputs for them. But those suppliers also have a limited amount of goods. Eventually you get to root goods, e.g. mining labor and mines.

Consider how a mine operates. It has workers working a certain amount of time and producing a certain amount of ore. If the mine wants to increase the amount of ore that it produces, it has to pay its workers overtime or hire new workers. But if it hires new workers, they are likely to be less productive than the existing workers. The existing workers may even have to slow down so as to explain how to mine. So either way, it is more expensive for the mine to produce more ore. To cover their expenses, they increase prices.

In a normal economy, this is healthy. Some of the people buying the ore may choose not to buy at the new price. Or they may cut their profits because their competitors aren't raising their prices. Even if they increase the prices of their products, this might get balanced by someone else cutting prices.

In an inflationary economy, this natural adjustment may constantly fall on the side of increasing prices. And as everyone's costs increase, they feel the need to pass on the cost increases to their customers. Because otherwise, they would be making less money. Then there is inflation, which means that the same profit they used to make is worth less. To try to keep their income on pace with their costs, they increase their prices. But that causes more inflation...

What's money have to do with this? Consider a tiny economy. There's a farmer and a government employee. Both of them are constantly a bit hungry, as the farmer can't grow much. He has to import water for irrigation from a neighboring country. He exports some food so as to afford the water. He pays \$300 a week for taxes. The government employee is paid \$300 a week and pays it all for food (she owns her own house, is exempt from taxes, and doesn't have anything else on which to spend her salary).

The government employee has a brilliant idea. She prints an extra \$100 in currency. This gives her \$400 in salary. She goes to the farmer and asks for more food. The problem is that he doesn't have more food. The \$300 of food that he has now is all the food that he can possibly produce after he eats his own \$300 worth of food and trades food for water. He needs the water to produce the modest amount of food that he grows now. And he needs to eat too. He's already constantly hungry. He can't eat less food. So he increases his prices. He sells the same amount of food for \$400 as he used to sell for \$300.

Now the government employee has a problem. If the new price is \$400, she needs to raise her pay. But the government only has \$300 in revenue. So she has to raise taxes too. So the farmer pays \$400 in taxes. The government employee makes \$400 in pay and spends it all on food. That's inflation.

You ask why can't the farmer just keep prices the same but limit the amount sold. But the government employee won't be satisfied with that. She's hungry. She'll increase his taxes so that he needs the extra money.

In this simple example, everything works out. They just create a new stable situation. But what happens if she keeps printing money? Prices and taxes and pay keep going up. Soon enough, the farmer expects to have to charge a higher price each week. This is called hyperinflation. Inflationary expectations are feeding the inflation.

The real problem here is that they need to produce more food. Perhaps the government employee should quit working for the government and work for the farmer instead. The farmer could pay in food if the tax rate is dropped to zero (with no government employee to collect taxes). Perhaps the two of them together could find a way to get a 33% improved yield without additional water. Maybe they catch water runoff and carry it back to the field. The point being that if they improve productivity, they can really benefit. Whereas printing money, they get no real benefit, just inflation.

Real economies work the same way. They just have far more moving parts. But they still need productivity growth to make real gains. Just having more money around doesn't help. What's needed is more goods.

Answer 6

UPDATE 6/18/2020

The below answer contains some interesting concepts and ideas, but is overall pretty flawed and does not reflect the MMT view of inflation. I'm going to leave the answer untouched, but am providing the much more accurate answers and sources (each is a Twitter therad):

• What inflation is NOT.
• The academic response to “What is MMT’s theory of inflation?”
• And finally, the MMT view of hyperinflation.

The above and more have been consolidated into a mega-thread (thread of threads) with everything I currently understand regarding the MMT view of inflation.

Original (flawed) response

The idea that “creating money causes inflation." is as ridiculous as saying “birth causes crime." (I mean, all criminals are born, amirite?)

Money creation has absolutely nothing to do with inflation. Here are Modern Monetary Theory (MMT) economists John T. Harvey and William Mitchell elaborating on this concept.

The only thing that can be inflationary is spending money on fully employed resources, where "fully employed" means, "No more people left to hire, no more products left for sale."

Inflation is not when the price of a single product goes up. It’s not when the price of all products in an entire industry go up. Inflation is defined as when the "price levels of goods and services" for sale in an economy (a particular currency, such as the United States Dollar) go up and continue to go up. Roughly speaking, inflation is when the price of "everything" (that an average household purchases) goes up and continues to go up

This is inflation. Is this a bad thing? What if you were 50,000 dollars in debt. Is that a bad thing? Well, how many assets do you have? $107,000?

$107k - $50k = $57k net worth

So, in this particular case, $50k in debt is not a bad thing. You need the full picture!

This is inflation too. Is this a bad thing?

Since your wages are keeping right up with prices, do you really care that the prices are going up?

This is inflation too. Do you really care? In this case, you can more than cover the rise in prices.

This is clearly a bad thing. But why is it bad? Prices are not necessarily going up unreasonably, our wages are being kept artificially low! Our corrupt system is forcing us into poverty and private debt.

This, too, is a bad thing. But, again, why? Prices are being raised artificially high. Our wages are now rising, but our corrupt system also allows companies to unfairly take advantage of us. This is price gouging.

The US pharmaceutical industry regularly price gouges American citizens, and the government does absolutely nothing to stop it because they’re legally bribed to not stop it.

‪Inflation can also be a good thing! The government could increase taxes on activities that harm society, such as those that cause pollution and climate change. Artificially increasing the price – choosing to cause inflation – for the greater good. (It can be done the other way as well: decreasing taxes on activities that prevent pollution and climate change.‬)

(Inflation is most definitely a good thing to the price gougers.)

‪

Here is actual inflation in the United States since 1960. The only substantial episodes were the 1970s OPEC oil supply shocks. They deliberately withheld their product in retaliation for our support of Israel. (Our decision to only use fossil fuels didn’t help much.) This obviously has nothing to do with “creating money.”‬

But beyond that, no inflation to be found!

And yet, during this entire time, every single dollar of federal spending was financed with created currency.

The point is this: "Inflation the Boogeyman" is totally different than inflation in reality. We understand the nature of inflation. We have many, many tools to prevent, measure, and respond to it. Many of those tools can be automated in order to bypass fickle and corrupt politicians.

‪Finally, hyperinflation occurring in an economy such as the United States is not only unlikely, it’s absurd. Here is economist Fadhel Kaboub on the specific example of Venezuela:

The primary tool (strongly) recommended by Modern Monetary Theory (MMT) is the Federal Job Guarantee, which solves the scourge of involuntary unemployment and would prevent much of inflation. It also sets up a suite of automatic stabilizers in order to bypass fickle and corrupt politicians.

‪Here is a taste of inflation in reality, by MMTers Economist Scott Fullwiler, and experts Rohan Greay and Nathan Tankus. For more inflation-in-reality by #MMT economists, search for "inflation" and "[I*]" on this page.

To learn more about MMT in general, start here:

• On the web: Geoff Coventry's Modern Money Basics, New Economic Perspectives, and Naked Capitalism (general news through an economically accurate lens)
• My pinned tweet-thread on Twitter contains many expert-created sources and people to follow.