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Do Federal Deficits Cause Inflation? (Vol. 39)

Updated: Feb 7, 2023

analyticsbox | Feb 16, 2022


Federal Government White House

The answer isn't black or white. It depends on how it is financed.

As we know, the Federal Government has been consistently spending more than its income, which means we have a deficit (loss in business terms). Only three times in the last 60 years have we had a surplus (profit), in the late 90’s.

What is the economic impact of these deficits and does it cause inflation?

Actually there are many impacts, but two key impacts are inflation and slowed economic growth (See No Spin #16, The Formula for Growth). Obviously when we have a financial loss (deficit), we have to get the funds to cover the loss from somewhere. So how do we finance the loss? There are essentially two primary ways - borrow from the public or private institutions, or print the money. The difference is very important.

(Fiscal policy determines the deficit, Monetary policy determines how we pay for it.)

Let’s assume the government has a one Trillion dollar deficit. That means it puts into the economy one Trillion more than it takes out in taxes or other revenue sources. If it borrows that money from the public/private sector, then the net effect on inflation is a wash, no increase in the money supply. It takes out the same amount it puts in.

If the government prints the money, there is a one Trillion dollar increase in the money supply (it doesn't literally print the money and the mechanics are a bit complicated, but the net result is an increase in the money supply).

When the money supply grows faster than the growth in output, you have the classic definition for inflation. So let’s take a look at the M2 money supply growth (M2 is a broad definition of the money supply) since 2010, along with inflation rate and economic growth (data from the Federal Reserve of St. Louis).



Looking at this, inflation seems somewhat subdued relative to the growth in money. However, another factor is the Velocity of money (V), that is how fast it turns over (how quickly we spend it or not - increased saving would reduce V). During this period, V slowed which partially offset the growth in money supply, which resulted in lower inflation.

Inflation is a delayed reaction to money growth and there are many factors that influence inflation and economic growth (e. G. Velocity, the pandemic, supply chain issues, etc.), so there is not a direct correlation. There clearly is a relationship as evidenced by the surge in inflation in 2021 after the historic growth in money supply in 2020. Because money continued growing rapidly in 2021 (although not as rapidly as in 2020), and V increasing as folks came out of the recession, we would expect continuing high inflation in 2022.

So now we know the problem, but how do we fix it? The answer is simple, the implementation of it is very difficult. We need to get control of the Federal spending and reduce the deficits and eventually balance the budget. In the meantime, we need to quit printing money as fast as we have been, and go back to modest increases in the money supply commensurate with our growth in output and modest inflation.

BOTTOM LINE

The huge increases in the deficits in recent years have been largely financed by printing money - a rapid increase in the money supply - and when you increase the money supply faster than output, you get higher inflation. The laws of supply and demand really work. Certainly there are other factors that affect inflation, such as supply chains limiting supply of goods, or energy policy limiting supply of oil, etc. But when the money supply grows faster than output, you get the results we are seeing today - inflation increasing significantly.

The solution is clear, but politically difficult. We must find fiscal and monetary discipline to solve this and other economic problems resulting from runaway spending.

It is not magic; it is Econ 101.

LEARN ECONOMICS, THEN VOTE SMART

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