Cecil Bohanon & John Horowitz: Yes, printing money during COVID led to inflation

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Did the federal government print money to spend for COVID relief and other expenditures, and is that why we are now experiencing inflation? Any first-year macroeconomics student should know it isn’t that simple. But when we look at the effect of Federal Treasury/Federal Reserve financing, this assessment is mainly correct.

When the Federal Treasury spends more than it collects in revenue, it borrows the difference rather than printing money. The Treasury borrows by selling bonds, competing with other borrowers for the available funds. When the Treasury borrows to finance its excess spending, other borrowers cannot borrow those funds to finance their excess spending. In other words, when federal and non-federal borrowers compete for the same funds, the net effect of government deficits on economy-wide spending and inflation is zero.

However, the Federal Reserve can create new money and supply it to the Treasury by buying Treasury bonds. The Treasury can sell its bonds directly to the Federal Reserve or to private parties. When the Federal Reserve purchases bonds from private parties, commercial banks’ reserves increase, allowing those banks to make further loans, which creates additional money. When the Federal Reserve buys bonds directly from the Treasury, the Fed adds money to the government’s checking account, but adds no new reserves to commercial banks. Although there is a distinction between the two methods, the effect is the same—overall spending increases when the Federal Reserve provides additional cash, and the additional cash bids up prices.

Nobel Prize-winning economist Vernon Smith used the following analogy to illustrate the effect of the Federal Reserve’s recent policy of directly buying Treasury bonds. “Suppose I spend in excess of my deposits at my bank. My bank simply issues bonds for the excess and holds them for me. In effect, my bank facilitates me spending whatever I want. No intelligent bank would do this because of the risk of my being a spendthrift. But the Federal Reserve risks only inflation, borne by the citizens.”

Moreover, the Fed can then say: “We didn’t cause inflation, and we didn’t inject new reserves into the banking system! In fact, we are raising rates to slow this down. Inflation was not our policy—but we will heroically and bravely fix it!” Well. OK. But despite the financial machinations, in the final analysis, the federal government printed money to spend for COVID relief and other expenditures, and that is why we are experiencing inflation.•


Bohanon and Horowitz are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.

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One thought on “Cecil Bohanon & John Horowitz: Yes, printing money during COVID led to inflation

  1. Deficit spending is only part of the story. War, demand shift from services to goods, and pandemic-related supply disruptions also played a very large role. This can be seen in the fact that countries that did not deficit-spend to soften the impact of pandemic-related job losses are also experiencing very high inflation.