Friday, August 19, 2011

Inflation Comes from Spending Money, Not Creating It

A lot of people think that the act of creating money will somehow create inflation all by itself.  That is as ridiculous as saying the mere act of growing more food will solve world hunger(there's so much more to it).  Inflation is a complicated topic with few absolutes and a lot of misunderstanding.  In this post I want to debunk the myth that just by someone creating money, that it can cause inflation.

First of all, let's say that the federal government printed off 500 billion dollars in new bills.  You might think that this would automatically create inflation.  But what if the government took all that money, loaded it up into a rocket ship, and sent it to the moon?  Think that would cause inflation?  How about if they took the money and put it in a vault in Fort Knox - do you think that would cause inflation?  No, of course not.  The money was created, but never put into the economy.  If inflation is defined as "too much money chasing too few goods" then the key word most people forget to consider is "chasing".  Money sitting on the moon or in a vault in Fort Knox aren't chasing after any goods.

How about some more examples.  For instance, what about the federal government put money in a bank vault.  Would that cause inflation?  Not directly.  Because even though the money has been handed over to someone, it didn't take any resources out of the economy.  It moved money, but it wasn't in exchange for anything.  For something to be inflationary it must either add to aggregate demand without adding to equivalent aggregate supply, or take away aggregate supply without removing equivalent aggregate demand.  If the federal government gave dollars to a bank all day everyday, it wouldn't cause inflation as long as all the bank did with it was to put it in a vault and never spent it or lent it out.  The same thing goes if the federal government gave that 500 billion dollars to a person for free.  Unless that person spends the money, it won't be inflationary.

Of course, many of the things I've described will precede money being spent, and will indirectly cause inflation.  For instance, giving a person money will precede them spending it and causing inflation.  Giving money to a bank will precede them lending it out to someone who will then spend the money.  So while it is often the case doing those things can cause inflation, it's important to know that the act of creating the money doesn't necessarily cause the inflation until the money is spent.  Let's take a look at some real life examples where this distinction becomes important.

If the federal government sent  a hundred dollars to every citizen in the country that would be around 30 billion dollars created.  However, if everyone took that money and stuck it into their savings account, it wouldn't cause any inflation because it wasn't spent.  When people later take that money and spend it, it may cause inflation, but it won't affect aggregate demand or supply until people spend the money.  Another example would be if the federal government gave money to banks in exchange for their government bonds, it wouldn't automatically cause inflation.  It might lower interest rates, but unless those lower rates translate into more bank loans that are then spent into the economy, it isn't going to cause inflation.

A lot of people thought that the Fed's so-called  "Quantitative Easing" was going to cause massive inflation because more money was being pumped into banks.  It could have, but only if that money had translated into banks making more loans.  Since it didn't(or at least no significant) increase loans, it didn't do much to help the economy or increase inflation.  As this example demonstrates it's important to distinguish between what actually causes inflation, and things that have been observed to indirectly cause it.  Because otherwise, we'll all run around like Chicken Littles worrying about hyperinflation while the economy continues to tank.
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