This is a fallacy which confuses many people.
If we print more money, prices will rise such that we’re no better off than we were before.
In order to see why, we’ll suppose this isn’t true, and that prices will not increase much when we drastically increase the money supply.
Let’s suppose that the Gvernment decides to increase the money supply by mailing every man, woman, and child an envelope full of money. What would people do with that money? Some of that money will be saved, some might go toward paying off debt like mortgages and credit cards, but most of it will be spent. Maybe, I will go to the nearest Mall and buy a MacBook Air.
I’m not going to be the only one who runs out to buy a MacBook Air. This presents a problem for the Mall management. Do they keep their prices the same and not have enough machines to sell to everyone who wants one, or do they raise their prices? The obvious decision would be to raise their prices. If the Mall (along with everyone else) decides to raise their prices right away, we’d have massive inflation, and our money shall stand devalued. Since we’re trying to argue this won’t happen, we’ll suppose that the Mall and the other retailers don’t increase the price of MacBook Airs. For the price to hold steady, the supply will have to meet this added demand. If there are shortages, certainly the price will rise, as consumers who are denied a MacBook Air will offer to pay a price well in excess of what the Mall was formerly charging.
For the retail price of the MacBook Air not to rise, we will need the producer of the MacBook Air, Apple Incorporation, to increase production to satisfy this increased demand. Certainly this will not be technically possible in some industries, as there are capacity constraints (machinery, factory space) that limit how much production can be increased in a short period of time. We also need Apple Incorporation not to charge retailers more per machine, as this would cause the Mall to increase the price they charged to consumers, as we’re trying to create a scenario where the price of the MacBook Air won’t rise. By this logic we also need the per-unit costs of producing the MacBook Air not to rise. This is going to be difficult as the companies that Apple Incorporation buys parts from are going to have the same pressures and incentives to raise prices that the Mall and MacBook Air do. If Apple Incorporation is going to produce more MacBook Airs, they’re going to need more man hours of labor and obtaining these hours cannot add too much (if anything) to their per-unit costs, or else they will be forced to raise the price they charge retailers.
Wages are essentially prices; an hourly wage is the price a person charges for an hour of labor. It will be impossible for hourly wages to stay at their current levels. Some of the added labor may come through employees working overtime. This clearly has added costs, and workers are not likely to be as productive (per hour) if they’re working 12 hours a day than if they’re working 8. Many companies will need to hire extra labor. This demand for extra labor will cause wages to rise, as companies bid up wage rates in order to induce workers to work for their company. They’ll also have to induce their current workers not to retire. If you were given an envelope full of cash, do you think you’d put in more hours at work, or less? Labor market pressures require wages to increase, so product costs must increase as well.
In short prices will go up after a drastic increase in the money supply because:
If people have more money, they’ll divert some of that money to spending. Retailers will be forced to raise prices, or run out of product.
Retailers who run out of product will try to replenish it. Producers face the same dilemma of retailers that they will either have to raise prices, or face shortages because they do not have the capacity to create extra product and they cannot find labor at rates which are low enough to justify the extra production.
Inflation is caused by a combination of the following four factors:
The supply of money goes up.
The supply of goods goes down.
Demand for money goes down.
Demand for goods goes up.
We’ve seen why an increase in the supply of money causes prices to rise. If the supply of goods increased enough, factor 1 and 2 could balance each other out and we could avoid inflation. Suppliers would produce more goods if wage rates and the price of their inputs wouldn’t increase. However, we’ve seen they will increase. In fact, it’s likely that they’ll increase to such a level where it will be optimal for the firm to produce the amount they would have if the money supply had not increased.
This gets us to why drastically increasing the money supply on the surface seems like a good idea. When we say we’d like more money, what we’re really saying is we’d like more wealth. The problem is if we all have more money, collectively we’re not going to be any more wealthy. Increasing the amount of money does nothing to increasing the amount of wealth or more plainly the amount of stuff in the world. Since the same number of people are chasing the same amount of stuff, we cannot on average be wealthier than we were before.
