Ok, when inflation happens there is more money in circulation, right? But… where does the money come from? Who gets the money first? The government can’t just print money and give it to itself. I mean, then there would be no need for national budgets etc.
It would seem like the amount of money would be constant. But then, when you consider that money sometimes gets lost, it would seem like the total amount of money would always decrease. I know that’s not true, so what’s the answer to my original question?
Some governments do print money and give it to themselves. It’s a handy way to pay the bills if you don’t have enough taxes to cover your expenses. Of course, the inevitable result of just printing money is that the money quickly becomes worthless … .
This is one reason why people used to be so hot for the gold standard. If you tie the amount of currency in circulation to the amount of some physical commodity that the government holds you make it impossible for the government just to print new money to cover its debts. Most modern governments are responsible enough to be trusted with controlling their own money supplies.
In the modern world though, most large transactions occur without any money physically changing hands. Many things are bought on credit, and then paid out gradually later. The availability of credit means that the money supply is effectively larger than the actual amount of currency in circulation.
So for a modern government, controlling the money supply goes beyond just limiting the amount of cash in circulation. It also has to control how easy it is for people to borrow money. The United States does this by tweaking the rate that large banks can borrow money at from the Federal Reserve. The easier it is for banks to borrow money, the easier it is for them to loan money to businesses and individuals.
Let’s see if I can remember my college Introduction to Economics course. There are two types of inflation.
Cost-push inflation comes from an increasing cost of items for which consumers can’t find lower-cost alternatives. Let’s use gasoline as an example. You absolutely need 10 gallons of gasoline a week, but the cost rises from $1.50 a gallon to $2.00 per gallon. That’s an extra five bucks per week you have to spend on gasoline. Your boss gives you a $5/wk. raise to cover it. If everyone gets a $5 per week raise, suddenly there’s millions of more dollars a week to pay for the same amount of work, and all the bosses in the country have to raise prices to cover it.
Then there’s demand-pull inflation. Let’s say you trade in your old clunker for a sleek, new - but gas hungry - SUV. Suddenly you go from needing 10 gallons of gas per week to 15. If everyone in the country did the same, then there’s millions more gallons of gas purchased each week, and the cost will rise, at least until production and production efficiency rise enough to level things out.
Of course, the government could just print more money and hand it out, in which case you would have more dollars in circulation, but nothing more (either worker productivity, material goods, or something like gold to back the currency) to value the money against.
The idea of the government printing out more money primarily for the purpose of fundraising is not so incredulous. In fact there’s a formal term out there for the practice: seigniorage.
A lot of non-industrialized countries rely on this practice for government revenue. Unfortunately, the large increases in money supply results in rampant inflation, e.g. in Turkey’s case.
As to why they would do this, one of the reasons is necessity. Think of a small, poor country that needs to finance its government activities. What can they do? They can resort to taxing or borrowing or printing more money. Since this country is small and poor, taxing won’t do much good except place more burden on its citizens. And maybe its collection agents are corrupt and pocket a lot of the tax revenues for itself. Borrowing is ineffective because who has enough money to lend to the government? And who is going to trust the government of the poor country to pay them back after the time is up? So we’re left with printing more money, and that’s what many of these countries depend on.
No, money comes from the Fed. You often hear about the Fed raising or lowering interest rates, right? Well, that’s what governs the supply of money. If inflation starts taking off rapidly, then the Fed would raise its rates to stem the supply of money in circulation. After all, banks are going to be more hesitant to loan out money if they have to pay 20% for it instead of 2%.
You’re not getting it. Printing money does not automatically equal inflation. Read kunilou’s post… Those are the two main types of inflation that modern deomcracies deal with on a regular basis. Running the printing presses 24/7 is a cause too, but is far more rare than you seem to think. We haven’t even brought up the currency markets - where the dollar is valued against other currencies - so be prepared for that discussion when it comes.
Say you have a part-time job that pays $100 a week. Your boss gives you a check for $100. You take the check and deposit it in the bank.
Then you go to the ATM and get $20 in cash. How much money do you have?
You have $20 in your pocket, but your bank says you have $80 more that you can get any time you want it.
Does the government have to print that $80 and have it laying around, waiting for you to ask for it? No, because you may write a check to buy something, or use a credit card to charge something and then write a check to pay for it. You may not even need it at all that week, and just leave it in your account.
Suppose the same thing happens for 10 weeks. You’ll have earned $1,000, but you’ll only have received $200 cash. The rest will be in a computer record at your bank.
Multiply that by millions of people each week and you’ll understand why only a fraction of the “money” in circulation is actually in the form of cash.
And don’t forget credit. Let’s say you buy $1,000 worth of furniture on your credit card. Obviously, you’ll have to pay it back eventually, but not immediately. Does that mean the furniture didn’t really cost $1,000? Sure it did, but the government didn’t have to print the cash to pay for it.
I believe open market operations is the primary tool used by the Fed to increase or decrease the money supply. If they want to increase the money supply, they sell U.S. Treasury securities. If they want to decrease the money supply they buy U.S. Treasury securities. More Information
Inflation is “too much money chasing too few goods.” That can mean there is more money, fewer goods, or the existing money changes hands faster (the velocity of money), or any combination of the three. What we think of as “money” is termed M1 by economists which includes cash, checking accounts, and demand savings deposits. These are all highly liquid and can immediately be used to pay off debts.
The Fed has three tools to influence the money supply: Reserve requirements, the discount rate, and open market operations. The first two affect the money supply by influencing commercial banks’ ability/willingess to make new loans, while the last acts directly to add/remove money from the system. When a commercial bank makes a loan, it creates money by virtue of reserve requirements. Since a bank with $1000 in deposits only has to keep $100 in cash (10% reserve requirement), it can make $900 worth of loans. That $900 worth of loans is an increase in the money supply because not only do the original depositors have access to the $1000, but the borrowers have access to $900 as well. If the borrowers and depositors request more than $1000 on any given day, the bank has to borrow the balance from the Fed at the discount rate. Higher reserve requirements inhibit the ability for banks to make new loans (create new money), while a higher discount rate discourages them.
The other tool for the Fed to increase/decrease the money supply is open market operations. This entails the Fed either buying/selling US T-bonds, notes, and bills from/to commercial and investment banks. Since the Fed’s acount isn’t considered part of the money supply, when it buys securities from a bank, the money supply increases (The Fed gets the bonds and the bank’s reserves increase). If the Fed sells securities to banks, the banks use their own money to pay the Fed for the securities (which aren’t considered part of the money supply either).
The actual amount of paper money circulating is determined by the public’s demand for it. If the bank doesn’t have enough cash in it’s vaults, it asks the Fed to “print cash” and then that amount is deducted from the commercial banks account at the Fed.