Why Governments Create Inflation

Why Governments Create Inflation

♪ [music] ♪ [Alex] If inflation is so costly, why do some governments
create inflation? In our opening video
on hyperinflation in Zimbabwe, we gave one explanation. When the government prints money
and uses it to buy goods, that’s like a tax — a transfer of wealth
from the people to the government. Now inflation is not
an especially effective tax. So governments typically
use inflation as a tax only when they’re desperate. They can’t raise funds
in any other way. There are other reasons, however, why printing money
can benefit governments. And in some cases, printing money can even
benefit an economy. We’ll be examining these
in much more detail in future videos when we discuss how the government can use
fiscal and monetary policy to combat a recession. In this video, we’re just going
to give a taste of the basic idea. Recall the equation of exchange,
MV is equal to PY. Earlier, we used this equation
to explain inflation. And what we said is that since
V and Y are relatively stable, the only explanation for large
and sustained increases in prices is an increase
in the money supply, M. We also showed empirically
that in the long run, when M doubles, then P doubles,
just as the theory predicts. In other words, in the long run,
money is neutral. But what about the short run? In the short run, an increase in M, especially an unexpected
increase in M, that can increase real output. To understand why, let’s turn
to the parable of inflation. Consider a small economy consisting of a baker,
a tailor, and a carpenter, who buy and sell products
among themselves. Now think about what happens
when a government like that in Zimbabwe
starts paying its soldiers with newly printed money. At first, the baker is delighted when the soldiers
walk through his door with cash for bread. To satisfy his new customers,
the baker works extra hours, hires more assistants,
bakes more bread, and is able to raise prices. “How wonderful,” the baker thinks. With the increase
in the demand for bread, I’ll be able to buy more clothes
and more cabinets. Meanwhile,
the tailor and the carpenter are thinking much the same thing, as the soldiers are also
buying goods from them. When the baker arrives at the tailor
to buy shirts, however, he finds that he’s been fooled. The soldiers have bought shirts
for themselves and the price of shirts
has now gone up. In the same way,
the tailor and the carpenter — they discovered that the prices
of the goods that they want to buy — they’ve also increased. Although they earned more dollars, their real wages — the amount of goods that the baker,
the tailor, and the carpenter — the amount of goods
that they can buy with their dollars —
that has decreased. When the government
next wants to buy goods, it faces higher prices and it has
to print even more money to buy just as many goods as before. Moreover, as the new money
enters the economy, the baker, for example, will now race to the tailor
and to the carpenter to try and spend the money
before prices go up. V increases. Unfortunately, the tailor
and the carpenter — they’re likely to have had
the same idea. And the result is
that prices increase even more quickly
than the time before. Eventually, as the government
continues to print money and buy goods, the baker,
the tailor, and the carpenter, they’ll catch on. They’ll come to expect
and prepare for inflation. Instead of working extra hours,
the baker, tailor, and carpenter — they’ll realize that by the time
they get to spend their money, the goods that they want to buy will have already
increased in price. And knowing this, the baker,
the tailor, and the carpenter — they’ll no longer be so happy to see
the soldiers entering their shop, waving fistfuls of dollars. And they’ll no longer
work extra hours baking more bread,
selling more clothes, or building more cabinets. This is the parable of inflation. We learn two things of importance
from the parable. First, an increase in the money supply can boost the economy
in the short run. And by the way,
that can be a good thing especially if there’s a recession. But this power might also
be abused by governments to help swing, say, an election. Second, we also learn
from the parable that when the government repeatedly
tries to boost the economy by injections of money, the people come to expect
the increases in prices and they come to prepare. So, let’s think about this
using our equation of exchange: MV is equal to PY. In the short run, an increase
in M can cause an increase in Y. But then P catches up. So, in the long run,
the increase is in P only. But now notice the following: if the government wants
to reduce inflation, the entire process
goes into reverse. So a decrease in the money supply —
that can cause a recession. If M decreases, for example,
then in the short run, Y falls until P catches up. In the long run, a decrease
in M decreases P. But the long run may come
only after a short-run recession. So one of the biggest
costs of inflation is that reducing inflation
is also costly. A bit of inflation —
it seems like a good idea to boost the economy, but if you keep trying
the same trick over and over again, it stops working. And then you’re left
with all cost and no benefit. A reduction in inflation
at that point — it slows the economy
and it increases unemployment. So inflation has been likened
to a drug. The drug stimulates at first, but then you need more and more
to get the same stimulus until you need the drug
just to be normal. And finally, when you stop
using the drug, you get severe withdrawal pains. This is what happened
in the United States in the early 1980s. Inflation was increasing
in the 1970s, but by the time
we got to the late 1970s, it wasn’t helping any longer
to reduce unemployment. So, we got so-called stagflation: inflation and unemployment together. Then in the early 1980s
under Ronald Reagan, inflation fell, but at the price
of a very serious recession in 1981 and 1982. So another reason
to avoid too much inflation is that reducing inflation
can be very costly indeed. [Narrator] You’re on your way
to mastering economics. Make sure this video sticks
by taking a few practice questions. Or, if you’re ready
for more macroeconomics, click for the next video. Still here? Check out Marginal Revolution
University’s other popular videos. ♪ [music] ♪


76 thoughts on “Why Governments Create Inflation”

  • Please keep in mind what your listeners do with the information you present.

    Spend a bit more GMU money summarizing the most important points in the form of reminder-ideas which we can copy and paste into our computer and from there to comments in Facebook.

  • I think you failed to mention possibly a very important factor as in people are unwilling to spend under deflation as they expect prices to fall reducing incentives to spend like in Japan this is possibly another factor for government created inflation

  • I initially thought this video would answer a different question: Why do governments seem to be ok with some amount of inflation (even when they are not desperate). For example, the Federal Reserve has an inflation target at 2%. Why not 0%? Anyway, good video.

  • Christian Prepper says:

    7:09 So govt induced inflation is like an illegal drug & since illegal drugs are bad, govt "stimulus" is bad!

  • An important factor not considered in this video is that the baker, tailor, and carpenter are not longer business owners, they are employees. That means that they do not actually get to raise prices. No matter how much they do, the employers control what wages the baker, tailor, and carpenter make. And. as has been experienced by American workers for more than four decades, wages do not go up at the same rate as inflation; in fact, workers today are paid less than workers who did the same jobs and same amount of work three or four decades ago.

    Since big business can and does manipulate prices of everything from wages to raw materials, to finished goods, prices do not need to go up no matter how much the money supply increases. Does India want to raise prices of finished goods to keep up with inflation? Too bad! Manufacturing moved to China, done and done; prices can actually go down now. Joe wants a raise to keep up with inflation? Too bad! As the president likes to say, you're fired! Sally, who has been unemployed for four years will gladly take Joe's jobs for half the pay. Prices can actually goes down even further, money supply be damned.

  • King Solomon 333 says:

    Oil is low and food prices are high, these two should be parallel with each other but we have huge inflation thanks to QE3.

  • Only described a runaway inflation scenario. Note how production and employment can rise with targeted inflation. As long as printed dollars are being used to create production from unused resources, then you can even print without causing inflation.

  • If that is the case then why not set prices on products to correlate with the cost of making the product? Would that solve that problem?

  • Stephanie Mitchell says:

    I notice how when they speak about hyperinflation they always use Zimbabwe as the prime example. What about countries like Hungary who had a higher inflation problem than Zimbabwe? Or Yugoslavia, Germany or Argentina or currently happening (as of right now) Venuzuela?

  • how about doing episodes on small business, startups next time?
    You guys are great. Loved this channel.
    Nice information and attractive way of presenting them.

  • Rolfus Adolfus Malthus says:

    P only "catches up" in this example because of consumption by unproductive soldiers. It certainly is not an inevitable long-run consequence of increased M, as implied here.

  • Chhandama Chhangte says:

    Can you please answer my questions
    1.Can the government just print money without any gains2
    2.How is more money printed in a year?Do they print in according tho the product produce in a year(GDP).
    3.Do the federal reserve print more money out of the interest gain and from taxes they gain?

  • "Why do some governments create inflation?" What do you mean, some governments? I believe most governments create inflation, although most of those don't engage in hyperinflation.

  • As I said in my other comments on MRU's vids, I'm happy to see vids that promote understanding of economics. Unfortunately, economics and politics are becoming intertwined, which in itself is ok, the problem is that readers don't realize that watching video's like these they are accepting a political philosophy, not just economic theory.

    With that, here is my reaction to this video…

    @1:45 "When M doubles P doubles.

    Here is the graph that shatters the QToM.

    Monetary base:

    To understand why this video is wrong you have to go back to another claim by Prof. Tabarrok, that banks lend customer deposits to other customers. This is false (banks lend money to each other, not customers).

    I write about here:

    And if you don't want to believe "some guy on the internet" I offer the following:


    Ok, ok, so if you can believe that banks don't lend customer deposits to other customers (banks used to lend that money to each other, today they sit on it and earn interest) then you might be able to understand why the QToM is just plain wrong.

    When banks lend, 4 things happen:

    1) They take an approved loan application (typically called a promissory note) And deposit it.
    2) Now that the bank has an asset, the bank can create new money equal to the value of that asset
    3) The money the bank creates is deposited in the borrower's account
    4) The borrower has a liability equal to the amount borrowed

    #1-4 are always equal and all NET TO ZERO!

    This means that banks do not lend customer deposits! If you are an econ student and have moved past econ 101 this should ring true.

    When the 2008 crisis happened, the value of many promissory notes was defaulted on (#1). Thus #1-4 were no longer equal in the private banking system. Trillions in bank assets were rendered worthless and as a result, trillions of dollars were quite literally deleted (which is why the banking system froze). The result was that bank liability, relative to bank assets increased and threatened to undermine the banking system. The Fed (part of the government) in coordination with the Treasury, bought mortgages that threatened to further undermine the system and purchased bonds to increase bank assets on offset the losses to #1.

    Thus, MV=PY is wrong, or at least it's wrong in the way it's taught.

    The Fed created trillions of dollars (M in the equation) from 2008-2012 and yet inflation has hardly moved. This is because non-payment of private debt (defaults) destroyed trillions of dollars (this is true because Prof. Tabarrok's understanding of bank lending ended some time shortly after gold stopped backing the currency (1934-1943 depending on who you ask) and the Fed created it and bought "assets" with it from the banks so that #1-4 would be back in balance and the banking system would stay stable.

    So the professors understanding and most other neoclassical economists are flat out wrong about Fractional Reserve Banking, Inflation and the Quantity Theory of Money.

    Professor Steve Keen has modeled this mathematically to prove it:


    If you are an armchair economist who deeply enjoys understanding, read this, if you are a political partisan who wants an economic theory to match your ideology, don't wast your time. If you are studying economics and plan to pursue, I deeply recommend you understand this.

    Any questions please let me know. Hopefully the Professor will respond.



  • So couldn't this be solved by putting laws in place that make it illegal to raise the prices of your products, so P remains a constant?

  • The video misses a couple of confounding factors in their parable.  Firstly, it assumes that government spending would be a net drain on the economy.  This certainly doesn't need to be true.  Government has a bit easier of a time profitably spending money, because the society can benefit from positive externalities, it doesn't all have to be first-order profitable.   Every printed dollar on the Manhattan project would have been an incredible investment at double the price.

    The second component is that it mostly ignores the banking system.   In general, we only want investors (not consumers) borrowing money, or money to be borrowed only as a way of increasing production. And then we use Schumpeter and bankruptcy to distill the wheat from the chaff.  Slight printing does a couple of things on this front*, but the main effect is that it allows companies that have slight negative (real) returns to continue existing.  It's essentially a form of workfare, but workfare that is market driven.  All of those employees/assets can still migrate to areas that provide superior (real) returns, but it also allows people to continue working while receiving a small subsidy.  Not only does this help prevent deflation, but also allows us to get people to pay for most of their needs, and then they're kept off of the actual welfare rolls that so many people hate.

    *The other effect is that surprise inflation allows producers to pay off their creditors more easily, and this becomes important ones you have too much rent-seeking behaviour in a society.  For the three producers in the parable, what's not mentioned is how much of their labour is being used to merely pay down their debt.  Once their debt is cleared, they literally have a greater (real) income with which to buy things in the economy.

  • Gustavo Rivas Méndez says:

    If all people knew this stuff, could the busyness cycle be smoothed out even more? Maybe if all people understood how this works, when they were told by the central bank that the money supply was going to shrink, the prices would start to fall sooner. Wouldn't that be a good thing? Or would self interest (if I lower the price first, and my neighbor doesn't, he'll earn more profit than me), prevent this from happening anyway, making prices to fall only when people start to suffer the real losses?

  • Javier Andrés Sosa Barco says:

    Nice explanation but Obama created 8 trillions of dollars from nothing, just printing it and giving them to the banks. So how do you explain there's not hyperinflation in the USA? Or can we say it has created hyperinflation in the housing and stock markets?


    So, inflation is unparalleled purchasing power. So, if the people in a country purchasing power is decreased. Isn't it become worrying ? Now happening in Indonesia, 30% lower purchasing power. Crap…

  • Inflation is the result of fiat currency systems meaning they are not backed by anything only your belief in it and willingness to accept it and it was what replaced the gold standard, all money is debt as the government borrows from the central bank or reserve with the promise to pay back interest so if the first ever 10mil say was put in to circulation in the country but interesf is owed on it then how can the interest ever be payed off ! Add in fractional reserve banking which essentially means a bank can print 9 times what it has in real money and you get the idea

  • This is utterly ridiculous The market does not to respond perfectly to such action- if it did then the feds actions would be at best completely useless. What this policy does is cause untold economic and societal destruction purely for the purpose of extracting wealth from Americans and sending it right into the pockets of banks and their investors. Its nothing short of the greatest fraud ever pulled off.

    Even if you believe the lie that this could have any positive net impact to be true, no one should have that much power to pour out heaps of valueless bills into our economy saying jump while the entire american populous has no choice but to say how high. This crime should have been nixed a long time ago.

  • Benjamin Howell says:

    1:40 classic textbook definition of correlation doesn't imply causation. The money supply can increase but prices can also either increase, decrease, or stabilize.

  • Oops, he forgot to mention.. the baker's job was taken by frozen bread at the grocery store, the tailor no longer makes clothes because of brands like Calvin Klein, and the Carpenters cabinets are now made by robots. So……

  • I'm not so sure it is correct t say that the inflation was helpful even in the short run. When the baker was delighted to see the soldiers walking into her bakery with loads of cash, she had been fooled into believing that her business had become more profitable, even though the real economic condition of the market for bread remained unchanged. Under this new false delusion of grandiose profits, the bread baker makes several new investments to increase her productivity, in order to take advantage of what she thinks is a higher demand for her products. But these new investments, the new machines that she buys, the new workers that she hires, they wont turn out to be as productive as she thought they were. Once she realizes this, she will discover that those investments should never really have been made. We Austrians call this 'mal-investment', resources and capital equipment are being mis-allocated, because the price system is failing to do its job! The result in the long run will be lower long run growth, not just inflation, because once done, it isn't possible to undo mal-investments and mis-allocated capital with perfect efficiency. Especially if the government tries to make the boom times last as ling as possible.

  • Roger Vincoletto says:

    Thanks for the video, I always struggle when explaining inflation for people who ask about. Will definitely be showing this video for them!

  • Okay, answer me this! Who or what raises the price because as I see it, how does anything goes up for the exception of volume, the price of goods goes up on it's on?

  • GDP can be faked .
    The GDP is a report card of the gov. It cannot be audited by an independent body. Only the gov has the data. The gov will fake the GDP to keep themselves in power. Search the internet for how is GDP audited. You will not find anything. The IMF and world bank base on fake data

  • David Johnson says:

    So Muabe's problem was that he printed money and gave to workers/public and lacked price control, when he should have given to the banks like they have done in the US, UK and EU, kept taxes low, came up with some Frank Dodd law and had IOERs to ensure liquidity in the system remained low?

  • This is not actually correct, the velocity of he money is NOT constant, it increases too when printing money!, that creates more inflation

  • The U.S. government does not increase or decrease the money supply. 100% of all inflation within the U.S. is the product of banks generating credit as loans and deposits. The supply of actual money is determined by depositor demand for the monetary medium and is not a factor in inflationary credit creation by the banks. Actual money is defined/designated by 31 USC 5103.

  • I THE PREACHER says:

    Bullshit! The Canadian government used to print money in the 1970's if needed. For example they would have new money printed for such things as social programs. It didn't change a thing. It is ROTHSCHILD who manufactures all financial crisis. He has his tentacles every where. Rothschild is the worst SINNER on the (flat) earth. The Lord GOD rebuke Rothschild, Amen! Remember the Bible says, The Love of money is the root of all Evil. He loves money the most, therefore he is Evil.

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