Victor’s Insider Scoop on Why Printing Money Causes Inflation (with a really scary ending) …
January 1st, 2009 | top of page

The Quantity Theory of Money states that if money supply increases faster than real output then inflation will occur. Since I am not purporting to be an economist let’s use a simple example to see how this theory works:

Let’s say the economy produces 1,000 widgets, the money supply (the number of dollar bills printed and in circulation) is $10,000 and the population of the country is 10,000 (so each person has one $1 bill). The average price of a widget is $10,000 / 1,000 = $10. Now suppose that the government prints an extra $5,000 dollar bills creating a total money supply of $15,000 but that the output of the economy remains constant at 1,000 widgets. Effectively, each person has more cash since $15,000 is now being shared by the 10,000 people (each person has $1.50 vs. $1.00). But, because each person has $1.50, they are now willing to spend more to buy that same widget.

The price of the 1,000 widgets will increase to $15,000 / 1,000 = $15 each vs. $10 previously. The price has increased but the number of widgets has stayed the same. The people have more money ($1.50 each) but they are not better off because widgets now cost $15 each so the value of their money has decreased; e.g. each $1 bill buys fewer widgets than it used to.

If the money supply is increased and the number of widgets produced stays the same, the widgets will become more expensive. Simply, if output increases by 5% and the money supply increases by 7% then inflation will be roughly 2%.

So, if you have bought in to the Quantity Theory of Money even a little bit (for there are competing theories like Keynesian analysis) here comes the really scare part.

The graph below comes from The Federal Reserve Bank of St. Louis

The thin blue line shows the number of dollars printed over time; the grey shaded vertical bands denote periods of recession. As you would expect, the line has trended up from the inception date of 1918 and begins to steepen its climb after 1970. But look closely at what happens in mid-2008: the line goes almost vertical and more than doubles from $800± billion to $1,700± billion!

That’s a lot more dollars in circulation at a time when the country is producing a lot fewer widgets. A period of inflation may be at hand.

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