Why does printing more money cause inflation?
When the money supply grows faster than the economy's output of goods and services, more dollars are spent on roughly the same goods, so sellers can raise prices and the general price level rises. Each dollar then buys less, which is what inflation means.
Watch it explained
Why does printing more money cause inflation?
A tiny island economy has 100 loaves of bread and $100, so a loaf costs $1. The printer doubles the money to $200 while the bread stays the same, more dollars chase each loaf, the price rises from $1 to $2, and each dollar buys less.
Scenes, in order:
- Twice the money, same bread
- A tiny island economy
- The printer runs
- More dollars chase each loaf
- Inflation: each dollar buys less
The mechanism: more money, same stuff
Money is a claim on goods, not wealth in itself. If a central bank creates new money and it gets spent, households and firms try to buy more than before. Producers cannot make more goods overnight, so shelves empty faster and sellers find they can charge more and still sell out. Wages and input costs follow, and the general price level ratchets up.
Economists summarize the link with the quantity equation, MV = PY. M is the money supply, V is velocity (how many times a dollar is spent in a year), P is the price level and Y is real output. In growth rates it is roughly: money growth + velocity growth = inflation + real output growth.
A worked example
Suppose the money supply grows 10% this year, real output grows 3% and velocity stays steady. Then inflation is about 10% minus 3%, or 7%. The money that output growth can absorb does not push prices up; the rest does.
The film on this page shows the simplest case. A tiny island has 100 loaves of bread and $100, so a loaf costs $1. The printer doubles the money to $200 while the bread stays the same, and the price of a loaf rises to $2. If you want a different version, type your own question into Isotoon, for example one about velocity or hyperinflation, and the video is built around that instead.
What the simple story leaves out
The quantity theory works best over long periods and with very large changes in money. In the short run, the link is loose for a few reasons:
- Velocity can fall. If people and banks hold on to new money instead of spending it, prices barely move. After 2008, the Federal Reserve greatly expanded bank reserves, yet inflation stayed low for years, partly for this reason.
- Output can rise. In a recession with idle workers and factories, extra spending can raise production before it raises prices.
- Effects arrive with lags, often a year or more, and expectations matter: if people expect inflation, they raise prices and wage demands sooner.
This is why AP and college courses treat the quantity theory as a long-run model. For how a central bank pushes the other way, see how interest rates slow inflation.
Common exam mistakes
- Calling one price rising "inflation." Inflation is a rise in the general price level, not the price of gas alone. A single price moving is usually a supply or demand shift.
- Treating money as wealth. Doubling every dollar does not double what a country can buy, because the goods did not double.
- Forgetting real output. If Y grows as fast as M, prices can stay flat.
- Mixing up nominal and real values. A raise smaller than the inflation rate is a cut in real terms.
More on money and markets is on the economics page.
Questions
- Does printing money always cause inflation?
- Not immediately or one for one. If velocity falls or output is growing, new money can be absorbed with little effect on prices. Over long periods, money growth far faster than output growth is reliably followed by inflation.
- Why can't the government just print money to pay for everything?
- Because printing money does not create goods. If the extra money is spent, it bids up prices, so each dollar buys less and the real value of everyone's savings and fixed incomes falls. Extreme cases of this are called hyperinflation.
- What is velocity of money?
- Velocity is the average number of times a dollar is spent on final goods and services in a year. It equals nominal GDP divided by the money supply, and it changes when people choose to hold more or less money.