Why does increase of national debt of the USA not lead to inflation?

Question

Increase of national debt is increase of money supply. But why does increase of national debt of the USA not lead to inflation?

Thanks.

Answer 1

Increase of national debt is increase of money supply. But why does increase of national debt of the USA not lead to inflation?

The premise of your question is simply wrong. Increase of national debt is not necessarily increase in money supply. New government debt can be accompanied by increase in money supply when the new government bonds are bought up by central bank against fresh reserves, since these new freshly created reserves will constitute increase in money supply.

However, if you or I or any other private entity or foreign governments buy US bond they are not doing that with freshly created reserves. They do that out of pre-existing money stock. So your premise is wrong.

Increase in money supply accompanied by increase in government debt actually leads to more inflation. That is actually the central theme of Cochrane's recent book the Fiscal Theory of the Price Level. Currently also US experiences high inflation, which happened right after a lot of US debt was purchased by Fed, and Cochrane argues, and provides evidence for, this being the reason why original rounds of QE that also increased money supply did not lead to large inflation but the last 'covid round' that focused on government debt did.

Answer 2

By accounting identity, government spending more than it collects back in taxes results in an increase in the base money supply (liabilities of the Treasury/central bank).

Each year, the base money supply (reserves and cash) plus issued bonds increases by precisely the same amount as the government deficit for that year.

If you add up all government deficits throughout history (and substract any surpluses), you arrive at the total level of outstanding government liabilities (i.e. the national "debt").

However, government financial liabilities (reserves, cash, and bonds) only represent a portion of the total money supply available to agents in the economy to buy things.

Commercial banks are licenced to create credit denominated in the government's unit of account (i.e. the dollar in the US). They do this every time they create a loan for some borrower. New money is created and circulates within the commercial banking system. These newly created deposits are liabilities of commercial banks, not the government. However, they are still money, which you use every time you buy a coffee using your bank cards.

Inflation is an average increase in the price level of goods and services over time (specifically most modern economies use a "basket" of goods and services which represents what typical people spend money on. This makes up the Consumer Prices Index (CPI)).

The price level rises over time for several possible reasons. One is an increase in the total money supply. This could come from the government running deficits. Alternatively, the government could run a balanced budget and the commercial banking system could instead increase their deposit liabilities via new loans (this also increases the money supply). Or, as is more likely, some combination of the two occurs.

Typically, modern sovereign democracies have 'outsourced' (although still wholely owned by the gov) the job of managing the price level to their central banks.

Central banks have several tools at their disposal to achieve their inflation target and price stability. One major one is the control of the price of money via setting interest rates.

If the central bank pressures commercial banks to raise the interest rates they charge customers on new loans (and raise rates on customer savings), then borrowers are less inclined to borrow and savers are more inclined to save (often these are the same people).

The result is a contraction in the aggregate money supply of commercial bank deposit liabilities. Why? Because the rate and volume of new loans decreases but old loans are being paid back. Paying back a loan destroys the money that was created when the loan was made.

So by changing the price of money in the economy, the central bank is aiming to have the rate and volume of new loans being made to be less than the rate and volume of old loans being repaid. This contracts the money supply and reduces the spending power of agents in the economy, thereby tampering down inflationary price pressures.

The above is monetary policy.