By printing extra notes, a government increases the total amount of money in circulation. If that is not followed by an increase in production, there is more money to spend on the same amount of goods and services as before. Everything costs more, thus our money is worth less.
Money supply is the total amount of coins and notes in a country’s economy. More coins and notes in circulation means that the money is worth less. The U.S. Federal Reserve (Fed) rarely prints extra money. Instead, it uses other mechanisms to increase the money supply.
The Fed sets the reserve requirements banks must hold at any time. By lowering those requirements, the Fed can allow banks to inject more money into the economy.
By lowering short-term rates at which banks borrow money from it, the Fed can make money cheaper and thus more widely available.
Open Market Operations
The Fed can use its reserves to buy government bonds and in that way release extra cash into the economy. It can also reduce the amount of money in circulation by selling those bonds.
Each of the three ways of increasing money supply can lead to inflation, which is a sustained increase in prices over a period of time. Inflation devalues our money by reducing our purchasing power. Although we may have more dollars to spend, they buy less then before because prices have gone up.
Benefits of Extra Money
Sometimes the benefits of extra money in the economy outweigh the costs of inflation. In times of recession, extra money helps revive the economy, while a devalued dollar makes U.S. exports cheaper and more competitive abroad.
- "The Ascent of Money"; Niall Ferguson; 2008
- Investopedia: How do central banks inject money into the economy?
- Pennies on the Dollar - one dollar bill with pennies. image by Andy Dean from Fotolia.com