Big Idea Nine: Prices Rise When the Government Prints Too Much Money

Inflation is an increase in the general level of prices.

Yes, economic policy can be useful but sometimes policy goes awry, for instance, when inflation gets out of hand. Inflation, one of the most common problems in macroeconomics, refers to an increase in the general level of prices. Inflation makes people feel poorer but, perhaps more important, rising and especially volatile prices make it harder for people to figure out the real values of goods, services, and investments. For these and other reasons, most people (and economists) dislike inflation.

But where does inflation come from? The answer is simple: Inflation comes about when there is a sustained increase in the supply of money. When people have more money, they spend it, and without an increase in the supply of goods, prices must rise. As Nobel laureate Milton Friedman once wrote: “Inflation is always and everywhere a monetary phenomenon.”

The United States, like other advanced economies, has a central bank; in the United States that bank is called the Federal Reserve. The Federal Reserve has the power and the responsibility to regulate the supply of money in the American economy. This power can be used for good, such as when the Federal Reserve holds off or minimizes a recession. But the power also can be used for great harm if the Federal Reserve encourages too much growth in the supply of money. The result will be inflation and economic disruption.

A billionaire in Zimbabwe
AP PHOTO

In Zimbabwe, the government ran the printing presses at full speed for many years. By the end of 2007, prices were rising at an astonishing rate of 150,000 percent per year. The United States has never had a problem of this scope or anything close to it but inflation remains a common concern.

Amazingly, the inflation rate in Zimbabwe kept rising. In January of 2008, the government had to issue a 10-million-dollar bank note (worth about 4 U.S. dollars), and a year later they announced a 20-trillion-dollar note that bought about what 10 million dollars had a year earlier. In early 2009, the inflation rate leaped to billions of percent per month! Finally, in April of 2009 the government stopped issuing the Zimbabwean dollar altogether and permitted trade using foreign currencies such as the South African rand and U.S. dollar.