Wednesday, March 11, 2009

Printing Money and Deflation

Since the Bank of England's recent announcement about increasing the money supply, there has been much interest in the impact of Quantitative Easing - increasing the money supply by the Bank of England effectively creating money.

Many have linked to a post where I explain how printing money can lead to hyperinflation.

However, this is only half the story. In normal times, printing money faster than growth of Real Output does cause inflation (and indeed could cause hyperinflation). But, these are not normal times.

This recession is very deep, therefore, people are holding onto their money and not spending, meaning increasing the monetary base may be necessary simply to avoid deflation.

In more economic terms, the velocity of circulation is falling; this means in the short term at least, an increase in the money supply does not cause inflation. For more details see: Link between money supply and inflation. This is why the US has experienced very low inflation, despite a dramatic increase in the money supply.
The problem may occur when velocity of circulation starts to rise as the economy recovers. If there is difficulty in removing excess liquidity we may well get inflation. But, I feel we have to deal with problems in order of priority.

The most pressing and dangerous problem is threat of deflation and the plunge in real output. This is first thing we have to deal with. The prospect of future inflation should not be ignored, but, we can't give priority to inflationary problems in the midst of a depression, with falling output and rising spare capacity.

- To avoid quantitive easing because we might get inflation in one years time, is like not putting a jumper on at night because next morning it will become hot. The point is you put on the jumper because it is cold, but when it gets hot you take it off again (well, that's my attempt at an analogy anyway...)

A further complication is the extent to which an increase in the money supply actually increases the money supply. (Basically, it depends on banks willingness to lend and any money multiplier effect). I will try look at this tomorrow.

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