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YOU DECIDE: Will deficits lead to inflation?

January 08, 2010

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu


Dr. Mike Walden
Media representatives:For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

It seems like it's hard to get everything right with the economy. As one problem passes, others emerge. This is the way many see the current economy. With the problem of the deep recession beginning to fade, the potential for higher inflation looms ahead.

Indeed, many say higher inflation is inevitable because of something the federal government has been doing to fight the recession - borrowing record amounts of money. Last year the government borrowed over $1 trillion to fill the gap between spending and tax revenues, and the red ink is expected to continue flowing in the coming years.

The worry is that all this borrowing and spending by the federal government will eventually cause prices to rise more rapidly, which is the definition of a higher inflation rate.

But is there a direct link between federal budget deficits and inflation? The perhaps surprising answer given by most economists is, no! While higher inflation rates can certainly occur at the same time as larger budget deficits are appearing, a third factor must be present to tie the two together - money creation.

The late Nobel Prize-winning economist Milton Friedman asserted that "inflation is always and everywhere a monetary phenomenon." In a less formal way he said, "inflation results from too much money chasing too few goods."

The idea can be illustrated with a simple example. Say there's $1,000 in circulation and there are 100 identical widgets (economists' all-purpose fictitious product) for people to buy. People can only purchase widgets. In this case each widget will be priced at $10.

Now suppose the supply of money in circulation doubles to $2,000. Again, the only thing people can do with this money is spend it on widgets. If there still are 100 widgets available, now each widget will be priced at $20. So a doubling of the money supply, with no change in the supply of widgets for sale, has resulted in a doubling of widget prices.

Who controls the amount of money in circulation? The central bank of the U.S. - the Federal Reserve - does. So effectively, the Federal Reserve (often known simply as the Fed) controls the rate at which average prices rise, which is the definition of the inflation rate.

Note I said average prices - some individual prices can increase faster than others, and some can actually decline. The point is that when we look at the average of prices, how fast that average rises over time is strongly influenced by the amount of money the Fed is putting into circulation.

Yet what about the budget deficit? Doesn't a bigger budget deficit mean the government (here the Fed) necessarily prints more money?

The answer once again is no. Borrowing by the federal government and the printing of money are controlled by two separate agencies. Borrowing is done by the Treasury Department and money creation is - as I've said - a function of the Federal Reserve. There's no mandatory coordination between the two. Only if the Fed prints more money at the same time that the Treasury is borrowing more funds is there a link between the two actions. When this happens, economists have a term for it - "monetizing the debt."

Now as it turns out, we have had both significant borrowing by the Treasury and money creation by the Fed in the past year. Both actions have been used to fight the recession. So people who worry about inflation have good reason to do so.

Fortunately, at the moment inflation doesn't seem to be a problem. One reason is because a great deal of the new money created by the Fed is sitting in the vaults of banks - unspent - so it isn't in circulation. Also, the money that is in circulation is changing hands very slowly, which lessens its impact on prices.

Fed Chairman Bernanke, who is well aware of the inflationary dangers of excess money, has said he will drain the extra cash from the economy at the appropriate time. If he is successful, this will nip in the bud (as Barney Fife used to say) an inflationary outbreak.

Be aware, however, nothing I've said here should be interpreted as suggesting budget deficits don't create issues. They certainly do, such as the potential for higher interest rates, the crowding out of other federal spending and the shift of investment funds from private to public purposes. But higher inflation need not be one of the issues. The Federal Reserve has the ability to control inflation. You decide if the Fed will be successful!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ncsu.edu/waldenradio/

Posted by Dave at January 8, 2010 08:24 AM