Economics/Problem of generating too much money paper.
QUESTION: Please be aware that the following is not a homework question, so please so not advise anything like: "You may want to check your textbook on Money Markets and Monetary Policy.".
This is a real question of my life, which I face at the age of 33:
Letís say a country has inflation. As far as my understanding goes, the reason for inflation is that Governments needs to receive more money from their citizens by increasing the VAT, am I correct on that? Now, if the average salary does not increase on such a country, then people becomes poorer. To solve that, the Government may decide to increase the salaries. Is that such an easy solution? If ALL the prices get higher (food, houses, salaries, etc), then more money (paper and coins) will need to be available in the country. That is, more money will have to be printed. What is the problem with printing more money?
Thanks and regards,
ANSWER: Like many people thinking about their retirement, what you're referring to is called the time value of money, which basically just means that the value of money changes over time (usually going lower). Let's talk about what this means and how it happens.
When talking about the value of money, generally people are talking about the purchasing power of money (with exchange rate being the other possible option, but that won't apply here). The purchasing power of the money refers to the changing ability of a fixed quantity of currency to purchase goods. For example, it took less currency for your grandparents to buy 1 loaf of bread than it would take you to buy 1 comparable loaf of bread. That means the purchasing power of currency has gone down, because it takes more currency to purchase the same things. The process by which a currency's purchasing power goes down is called inflation. Another way to look at it is that inflation occurs when prices go up. In contrast, deflation occurs when prices go down (increasing the purchasing power of the currency, since it takes less of that currency to purchase an equal amount of goods).
Note that inflation does not refer to a single product going up in price. Between 2002-2012, the price of computer memory (flash drives, SD chips, hard drives, etc.) went down dramatically, but the overall prices in the US went up. Some products, such as food or oil, can influence overall prices more than others, particularly if they are used in the production of a wide variety of other goods (contributing to the total cost of those goods), but, generally speaking, inflation and deflation refer to overall changes in price, not just price changes of a few goods.
You're incorrect in saying that the government causes inflation through VATs. Inflation actually comes from 3 primary places.
1) Cost-push inflation: This means that the cost of production increases, forcing businesses to increase prices. Some of the most common sources of cost-push inflation are food prices, energy prices, and average wages. Note that increased prices will often force employees to demand more money to keep up with prices, contributing further to cost-push inflation.
2) Demand-pull inflation: Occurs when Aggregate demand exceeds aggregate supply. At this point, companies must expand operations to keep up with demand, resulting in higher prices to make up for the increased cost of production potential. This is, of course, in addition to the price increases that result simply because customers are willing to pay it. Just as normal supply, demand, and price are all inherently linked, so is aggregate demand, aggregate supply, and national CPI (consumer price index, a common measure of inflation).
3) Monetary inflation: Monetary policy is used as a tool to manage the economy, which includes inflation. Monetary policy includes both the supply of money, as well as the price of money. The price of money is influenced primarily by adjusting interest rates (e.g.: if interest rates go up, then the price of borrowing money goes up). The supply of money is adjusted primarily through the printing/destruction of money, as well as adjusting bank reserve ratios. Since the price of money (interest rates) influence costs, they fall under cost-push inflation. That leaves monetary inflation pretty specific to just the quantity of money available on the market. For monetary inflation to be a problem, the people in charge of the nation's monetary policy have to be really dumb and just start printing money. It happened in Germany directly after WW1, it happened in Argentina during the late 20th century, etc. What happens is that the quantity of currency available as a ratio of the goods produced increases. Think of it like this: If the US doesn't increase money supply at all, but GDP goes up 10%, then there is less money for the amount of goods available, ceteris paribus, so this would contribute to inflationary pressure. In reverse, if the US prints 10% more money but GDP doesn't increase, then there's more currency for the volume of goods, and people will be exchanging larger volumes to compete for the same availability (again, ceteris paribus).
There's a handful of other sources of inflationary pressure, but they either tend to to indirectly influence inflation via the 3 methods above (i.e.: international interest rate differentials), or else they tend to be negligible.
Please note that each source of inflation will not necessarily directly increase inflation, but it will increase inflationary pressure. Say, for instance, that a nation's food prices increase 2%. The amount of inflation that will result, if any, will depend on the amount of existing inflationary pressure and the size/movement of the nation's economy at that time. Look at it like this: if you drink 3 beers, whether you're intoxicated will depend a lot on whether you've already been drinking, as well as the size of your body and whether you've been eating. Drinking those 3 beers will increase potential intoxication, just as high food prices will increase potential inflation, but whether these actually translate into intoxication/inflation depends on other variables as well.
When you're talking about the average wages in the US, it's something of a misnomer to say that people are getting "poorer". Average real wages for 98% of the population has been stagnant for decades. That is to say, that wages adjusted for inflation, have been flat. The top 2% of earners have seen increasing wages over the same period, though. When we're talking about "the poor getting poorer", we're actually talking about the disappearing middle-class. More people are entering working class and poverty, increasing the socioeconomic disparity.
One way that the government attempts to keep real wages in-line with inflation rates is to increase minimum wages (note that they've failed, as the minimum wages in 1970 would translate into about $9/hour when adjusted for inflation, compared to the current $7.25/hour). While this does contribute to inflationary pressure, that isn't necessarily a bad thing during a recession (during an economic boom, when inflation tends to be high anyway, it can become an issue). Higher minimum wages result in people making more. Since prices are sticky (they don't change immediately), this will reduce profitability in the short run rather than contributing to shortages, particularly since recessions come with inventory surpluses that need to be reduced before companies will hire people again. Anyway, when people make more money, then spend more money. Especially the lower income classes, where they spend a much higher proportion of their total income, higher wages contribute to increased demand. When demand increases, companies make more revenues and sell surplus inventories. When companies sell more, they hire people, contributing to high employment. Higher employment means people are making more money, which means they spend more money, and we end up in a national growth cycle, all contributing to inflationary pressure (which is why we don't do this during a boom).
The printing of money, as you may have guessed by now, is not inherently bad. It can be bad when done incorrectly, but it can also be helpful when used to stimulate spending and growth. As with any sort of expansionary monetary policy, whether you're hurting or harming the economy depends on what your goals are and how effectively you use the tools available to meet those goals.
Hopefully that answers your question.
---------- FOLLOW-UP ----------
QUESTION: Your response was excellent and very explanatory. However, please be aware that there is one phrase that I still do not fully understand:
"In reverse, if the US prints 10% more money but GDP doesn't increase, then there's more currency for the volume of goods, and people will be exchanging larger volumes to compete for the same availability (again, ceteris paribus)."
As I said, I do not understand: without an increase in the GDP but with more money printed... what would be the "bad" side-effects?
Thanks And Regards,
The effects of this wouldn't necessarily be bad. It could be good or bad, depending on economic circumstances. The effects will be consistent, but whether those effects help or hurt depends on what your goals are.
The results of printing more money will always be to increase demand, and increase inflationary pressures. Again, the degree to which this happens can vary. If the government prints only $1 extra, then it is highly improbable that there will be any actual increase of inflation as a result, whereas $1 billion extra most likely would increase inflation to varying degrees. So, please keep that in mind.
So, is it a good thing or a bad thing to increase demand and inflationary pressure? It can be either, depending on circumstances. During a boom cycle, specifically, increasing money supply when the economy is already in full employment and expanding broadly can result in unsustainable growth bubbles. Not only does the devaluation of currency increase the velocity with which money moves (meaning that people are spending greater volumes) while prices remain sticky, our exports also become cheaper relative to other nations as inflation devalues our currency in international exchanges, causing an increase in demand for our exports. This forces companies to greatly increase their production potential using long-term investment for an economic condition that is temporary, which will result in surplus production potential after that bubble ends, forcing companies to then fire people to cut costs, resulting in higher unemployment and debt problems as people who counted on that income to pay-off debt they've incurred default, causing lost revenues for companies, and potentially triggering the early stages of a bad recession. This is, of course, in addition to the resource inefficiencies that result from the artificially high domestic demand that causes nations to trade on currency fluctuations rather than comparative advantages. These inefficiencies also result in long-run loss of competitiveness as costs increase from factor price disequilibrium.
The goal of macroeconomic policy is to maintain constant and steady growth, as well as to translate that growth into development (in other words, turning our production potential into overall increased quality of life, rather than just greater volume of stuff). To reduce volatility, we must temper growth to sustainable levels, in addition to reacting to the early warning signs of recession. Note, please, that an inability of politicians to implement proper fiscal policy has nothing to do with economics, so don't blame the economists for that one. We get hired as analysts and consultants, but it's the politicians (who are usually lawyers or public servants) making the actual decisions in most cases.