INTRODUCTION –
What if there was an alternate reality where an individual was not taxed and instead, the government financed its expenses by printing new money. One would not have to give the government a percentage of his income despite availing services from them. One would not need to pay tax on his purchases, imported goods, land or his wealth. Imagine not seeing “taxes” on a bill anymore when one goes to a restaurant. More money is available in the economy due to the increased printing of money. So why does the government still prefer taxes instead of relying on newly created money by the central bank?
In this essay, it is argued that if the government relies solely on printing new money, it would lead to negative consequences. Even though newly created money can stimulate short-term economic growth by funding various programs, it could lead to several unfavorable outcomes including demand-pull inflation; a stagnant real GDP of the country due to a halt in supply; and depreciation of the currency because an inverse relationship exists between money supply and the value for money.
MONEY AND ITS FUNCTIONS –
Professor Francis Walker defined money as “Money is what it does”. It suggests that the functions of money explain what we mean by money. Today, as stated in the Economic Times, money is ‘a medium of exchange that is centralized, generally accepted, recognized, and facilitates transactions of goods and services.’ As a result, one of the main functions of money, among others, is its use as a commodity for exchanging products and engaging in transactions. Money is also used as a unit of account to measure the monetary value of different goods and services. Apart from this, it acts as a method to pay for future payments of debt.
Monetary policy is used to control the supply of money in a country. It uses interest rates and exchange rates to regulate the money flowing in an economy. The central bank of a country proposes various monetary policies in case of economic growth or recession. The bank sets the tax rates and decides on the quantity of money to be printed.
EFFECTS OF PRINTING EXCESS MONEY –
INFLATION –
One of the main consequences of relying on newly created money is inflation. It involves a sustained increase in the general price level of goods and services. Let’s assume an economy has a money supply of $100 million and has 10 million pens in supply. Each pen would cost $10 when $100 million (money in the economy) is divided by 10 million (supply). The next year, the same economy increased its money supply to $200 million by printing more money. However, the same number of pens are produced. This means that now, each pen would cost $20 ($200 million divided by 10 million). The price of the pen increased by $10 in one year, resulting in inflation.
The amount circulating in the economy increases when more money is printed. Individuals have higher income, leading to a rise in their spending. Consumers demand more goods and services, but there is limited supply. Businesses respond by increasing the price level of products which causes demand-pull inflation. Furthermore, workers demand an increase in wages to keep their income in line with inflation rates in the economy. It results in a wage price spiral, further fueling inflation as costs for a business increase, thereby increasing the price. In addition, if the cost of raw materials for the business rises more rapidly than the price of the final product, business experiences reduced profits. Shareholders receive low dividends and they may be unwilling to invest further due to low returns and uncertainty in the economy.
QUANTITY THEORY OF MONEY –
In addition, the quantity theory of money, as formulated by American economist Irving Fisher, states that MV=PT where M refers to the money circulating in the economy, V is the velocity of money, P is the price level and T refers to the amount of transactions. Several economists tried out this formula and found out that the velocity of money remains constant. As a result, if the money supply increases, the average price level will also increase. This formula suggests that there is a positive relation between money supply and inflation rates.
CASE STUDY –
For example, in 2008, Zimbabwe experienced a severe case of hyperinflation when the government printed excess money in response to debt and low economic growth. To fund for a war in the Congo and increase salaries to soldiers, the Zimbabwean government increased their money supply by printing more money. This soon became a temporary solution to soothe people who were relying on the government’s money. Furthermore, reforms were introduced to transfer agricultural lands to black farmers in Zimbabwe. However, unaware of proper agricultural practices, the new farmers were unable to produce sufficient crop which led to an agricultural shortage. Banks were reluctant to lend loans to new farmers due to their incapability to produce food.
According to a research paper published by the Pennsylvania State University, agriculture was Zimbabwe’s strongest export industry and due to the shortage, their export revenue fell. As a result of the negative economic growth, the country’s debt increased thereby leading to a spike in the rate at which new money was printed in the country to counter the rising debt. It resulted in inflation. With the agricultural supply shortages and rising demand due to printing money, prices rose by a higher margin. It led to cost-push inflation with workers demanding higher wages due to expectations of further inflation. By November 2008, the inflation rate in Zimbabwe was 79600000000% with the country printing notes valued at 100 billion and 100 trillion dollars. Zimbabwe dollars became worthless as they had no value.
IMPACT ON REAL GDP –
Furthermore, there is an increase in the nominal GDP of the country when the prices increase. However, the rise in nominal GDP is nothing but a money illusion. Printing money has made goods and services more expensive, but it hasn’t changed the supply which implies that if an individual has 100% more money, it doesn’t make a difference if all the products are valued 100% more expensive. More money does not enhance the real GDP of the economy, i.e. the true value of goods and services after being adjusted for inflation. The supply remains constant which suggests that the country’s productive capacity remains the same.
In the economy, businesses are unable to match the supply of their goods with the rapid rise in demand caused due to the newly created money, leading to inflation. Companies are reluctant to provide more job opportunities and may make workers redundant due to no growth in the economy. It contributes to higher unemployment, reduced spending, and lower living standards.
FOREIGN EXCHANGE RATE –
Apart from inflation, newly created money can also cause a depreciation in the value of currency. Assume that the exchange rate between India and USA is $1 = ₹100. India increases the amount of money it prints, increasing the money supply, that results in inflation. If the inflation rate in India is 100%, that is a book that used to be priced at ₹50 is now valued at ₹100, it means that USA will need twice as much Indian currency to purchase a book.
The value of Indian currency is depreciating against the US dollar. Import prices will drive up for the domestic citizens, reducing their spending on imports. The value of Indian Rupee weakens and devalues when compared to the US dollar. Moreover, due to depreciation, as the value of the money decreases, individuals look for more stable assets. There is a loss of confidence in the depreciating currency and thereby demand for other stable currencies.
HIGH ECONOMIC GROWTH –
Relying solely on money newly created by the central bank has certain positives to it as well. Printing more money would mean that the government has a higher budget. They would be able to fund for more programs to develop infrastructure, upskill labour, provide defense, and help in other sectors. Labour that is living in poverty will be encouraged to participate in programs to develop their skills. This will lead to higher labour productivity and efficiency when they make use of their new skills. Firms will be willing to hire these labour, increasing their income and reducing poverty levels in the country. Employment, living standards, spending and demand in the economy increases, leading to positive economic growth. Furthermore, printing more money will also allow the government to pay off their debts. During periods of recession, printing money can promote positive economic growth.
Despite these positives, the high economic growth in the country could lead to hyperinflation, causing severe consequences in the economy.
FACTORS TO BE CONSIDERED –
DEMAND –
However, printing money doesn’t always cause inflation. If citizens have low confidence in the economy, printing more money will not result in an increase in demand. Due to the low demand, businesses would be forced to bring their prices down. For instance, during the pro-longed economic downturn of 2008, many countries started printing more money. But, due to the depressed demand, the increase in the monetary base did not lead to a significant increase in consumer spending and businesses continued to reduce the prices of products, pulling down inflation. Therefore, one of the factors is the demand in the economy. A high demand would result in inflation in the economy whereas a low demand will reduce prices set by businesses.
PRICE ELASTICITY OF SUPPLY –
Additionally, another important factor to consider when printing more money is the price elasticity of supply (PES). Price elasticity of supply refers to the degree of responsiveness of the supply of a product to price changes. It is calculated by dividing the percentage change in quantity supplied by the percentage change in price. If the supply of a product is price elastic, it implies that the percentage change in quantity supplied is greater than the percentage change in price. It suggests that an increase in price means that the business can increase the supply of their product by a greater margin.
If businesses in an economy are price elastic in supply, it would mean that they can easily respond to any small increase in the price of a product (caused due to high demand resulting from an increase in the printing of money) by increasing the supply. It suggests that businesses will be able to keep up with the increases in price and demand by increasing the supply of a product. However, if the product is price inelastic in supply, businesses will be unable to increase their supply rapidly.
Hence, the demand in the economy and the price elasticity of supply should be considered before printing money.
CONCLUSION –
To conclude, newly created money by the central bank has detrimental consequences in the economy ranging from depreciation of the currency to hyperinflation. A government should base their decision of printing money on the demand and price elasticity of supply. The government can encourage businesses to increase their spare productive capacity, level of stocks and promote ease in the substitution of factors of production. It will allow businesses to increase their supply easily during periods of rapid increase in demand. Therefore, though printing money may appear like an enticing idea, the government should look into taxation as its primary source of revenue. Thus, I conclude that relying solely on money newly created by the central bank may not be a viable option.
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