Both economists and the general public are concerned with the printing of money. It automatically brings to mind hyperinflation in Weimar Germany in 1923 and, more recently, Zimbabwe. When a government prints currency more than economic production grows, the value of money decreases, resulting in inflation. When governments are unable to fund their borrowing by bond sales, they sometimes turn to print currency. This form of hyperinflation can be devastating to a country’s economy.
Printing Money – Example
Assume the market has a set number of goods (widgets). There are 20,000 at first, with a £10,000 cash supply. In this case, an average price of £0.50 (10,000/20,000) will be expected. Assume that the money supply is doubled. This means that the average citizen now has double the amount of income they had before. As a result, the 20,000’s nominal demand will rise. Since they have twice as much money, consumers are able to spend twice as much. Firms raise prices in response to the increased demand. The number of widgets remains constant. However, nominal rates and wages have increased. For a doubling of the money supply, we get a 100% inflation rate.
There is another case when the number of widgets rises by 20% in this situation. In addition, the money supply expands by 20%. In this example, there is a 20% increase in capital, but a 20% increase in products. As a result, premiums remain unchanged, and the inflation rate is 0%. When the money supply rises from 14,000 to 20,000, the grew in the money supply is greater than the increase in demand. Prices would begin to climb in this situation, resulting in inflation.
This clarifies the fundamental assumption that inflation will occur as the money supply grows more than nominal production. However, this is a simplified model that assumes variables like circulation velocity are constant.
Despite the risk of inflation, policymakers in Japan, the United States, and now the United Kingdom have resorted to quantitative easing (money printing) to cope with severe recessions and the possibility of deflation.
In a severe contraction, demand falls so low that the money supply can be increased without increasing inflationary pressure. (In contraction, the Velocity of Circulation decreases, so we may need to maximize money supply only to prevent deflation, according to the quantity principle of money MV=PT. V.) In most cases, printing money leads to inflation. It also has an effect on the exchange rate. Every specialist on the market or the best Forex brokers online will initially provide the client with the information that the worth of your currency is devalued when you print money. Inflation depreciates domestic shares, causing foreign buyers to flee the market.
However, printing money does not always result in inflation as the velocity of circulation (the amount of times money changing hands) is decreasing. The credit crunch has resulted in a decrease in circulation velocity.
How does it work?
There are several different ways quantitative easing is working.
- Reserves are generated by the central bank. This is the electronic creation of capital. Essentially, the Bank decides to increase its capital reserves by £50 billion.
- The Central Bank would use the excess funds to purchase a variety of government gilts as well as private-sector securities such as corporate bonds.
- Private banks sell their investments to the Central Bank, resulting in a boost in cash reserves. They should be more likely to lend money now that they have these cash reserves.
- The Central Bank raises the value of government bonds by purchasing them, lowering long-term interest rates. Long-term interest rates are down, which has a deflationary impact.
Then there is another question, does it actually work? Some argue that without quantitative easing, Japan’s stagflationary era would have been much worse. However, it is too early to tell for the United States and the United Kingdom. Quantitative easing is a high-risk strategy. When the economy recovers, one question is whether the Central Bank will be able to withdraw the surplus liquidity.
And there is also a reason why governments risk printing money if it could cause inflation. Deflation is much more dangerous than inflation. Deflation has the potential to transform a mild contraction into a long-term slump. Deflation is bad for the economy because it discourages investment and adds to the debt load.
Summing It Up
Finally, to sum up, the way the economy works is very difficult to perceive at a glance due to its complexity. There is no action that can be assumed as an absolute successful move because all of them have their pros and cons as they are linked to many other aspects of the economy. As we have seen from the above-mentioned facts and analysis money printing has different effects on the economy and we cannot say that it is an absolute good move or not. However, when it comes to the choice of whether to make this action or not, there is deflation on the other side of the scales. Thus in some cases, it can be a better decision, not the best.