How printed money increases inflation

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

14 September 2008

Lawi Kariuki would like to understand how “illegal” printing of money causes inflation. He writes: “Please explain to me how [this occurs]... refer to the following scenarios in your explanation: (1) Tourists visit our country and bring 1 billion shillings in foreign exchange into our economy. (2)  There are no tourists coming but we imagine they have come and brought in 1 billion shillings; so we print this amount of money and introduce it into the economy. Why will the second scenario cause inflation and not the first one?”

Well, Lawi, there is absolutely nothing wrong with printing money. Governments do it all the time. The problem is introducing it into circulation carelessly. But before we go into the reasons why, the two scenarios that you provided would not make any noticeable change in the inflation of Kenya.

This is because our economy has about one trillion shillings in circulation. Adding another one billion is just a drop in the ocean. One trillion is one thousand billions, thus the scenarios you give are equivalent to adding one shilling to a person who already has one thousand!

But if we add one trillion shillings to the economy at one go the inflation would shoot up whether that money came from tourists or the printing plant on Thika road!

The reason is this: when people have money, they want to spend it, otherwise the money is worthless. This increases demand for goods and services to the point of creating shortages. Suppliers respond by increasing prices (it’s a normal human behaviour) and inflation shoots up.

But the key issue is how the people get the money in the first place. If tourists visit and leave a trillion shillings behind that money will initially be in the hands of hotels, taxi drivers, the KWS, local airlines etc. This first group will get it in exchange for services and products sold to the tourists.

The second level to get the same money will be people who supply the first group. For example petrol stations will experience additional demand (fuelling more taxis and other vehicles that carry the tourists) and increase prices.

People in the tourism related businesses will not complain about the increased price of petrol, after all, they’ll have the money to buy it. It is only the rest of us “outsiders” who will fell the pinch.

On the other hand, if the one trillion shillings was simply printed, the question would be how to “introduce it into the economy”. Money is a medium of exchange for goods and services. So it can only be introduced through a process where the government buys something from “the economy”. This would have the same effect as the money from tourists.

Unfortunately, when governments print excess money, it is usually “given” to cronies without supplying anything in return. The “free” money is then spent in a wanton manner and it has devastating effects on the economy.

For example, we can decide to build a road using manual labour. Employ strong young people to do the work and then print money to pay them. There would be nothing wrong with that because the road would be useful to the society.