Why The Gov’t’s Covid-19 Spending Will Not Cause Inflation

Understanding the relationship between physical wealth, money, and the money supply

Image by pasja1000 from Pixabay

By David Grace (www.DavidGraceAuthor.com)

Congress has recently spent trillions of dollars to aid individuals and businesses that have been damaged by the Covid-19 lockdown. People worry that this massive spending may cause inflation.

To understand when inflation is and isn’t a risk, we first need to understand the fundamental nature of both money and the money supply.

How Inflation Is Related To The Money Supply

In the most simplistic sense, materially increasing the money supply above its previous level when there has been no proportionate increase in the country’s wealth or population will mean that more dollars will be available to purchase the same number of things and therefore prices will increase in order to establish a new balance between the amount of physical wealth (buildings, land, cars) and the amount of virtual wealth, money.

However, if the money supply has been materially reduced because of a material drop in the country’s wealth, increasing the money supply back up to its previous level will not cause prices to increase above the level they held before the money supply was reduced because the previous balance between the amount of physical wealth (buildings, land, cars) and the amount of virtual wealth (money) will be the same after the increase in the money supply as it was before the decrease in the money supply.

Returning the money supply to the level it had before it was reduced by a depression or pandemic is, in fact, a vital step in restoring a sagging economy to the healthy state it was in before the depression or pandemic occurred.

Money Is Not Bills And Coins

In order to understand the effect of the money supply on the economy, you first have to understand what money is, how it works, and what its role is in a modern economy.

Children think money is a physical thing — coins and bills.

If you think of money as a physical object, you will have a fundamentally flawed picture of the economy because you will think that the supply of money is fixed until the government prints more of it.

What Is Money?

The common definition of money is that it is a “medium of exchange,” and it is, but that doesn’t really tell you what you need to know.

Before Money Was Barter

I had pigs and I wanted a horse. Somebody else had sheep and he wanted pigs. A third guy had horses and he wanted sheep. None of us had a shared benchmark that told us what a pig, a sheep or a horse was worth in relation to each other.

Eventually, I might barter three pigs for four sheep and then trade four sheep for one horse. The process was slow, complicated, and inexact. In today’s terms a barter system has a lot of “friction.”

If we had had money I could have cut the sheep guy out of the equation and just given the horse guy some money, and I would have known how much money to give him because I would have known how much a horse was worth compared to what a pig was worth.

The Uses Of Money

Money 1.0, Physical Money

Firstly, in a general sense, physical money acts as a lubricant, a mechanism that reduces friction in economic transactions.

Secondly, money tells us the relative values of things, how much one thing is worth in comparison to another thing.

Thirdly, money allows people to convert a physical object like a pig into a few small, transportable coins, a virtual pig, and transfer that virtual pig to anyone they like in exchange for anything they want.

Old-fashioned physical money acts as an economic lubricant because it allows people to convert any kind of physical wealth into portable, transferable wealth and then back again into a different type of physical wealth.

The Problems With Physical Money

The first problem with physical money is that in order to buy something with it the buyer has to deliver a physical object, the coins, to the seller. That still leaves a lot of friction in the system.

The second problem with physical money is that the amount of physical money in an economy can only be decreased by physically destroying it or increased by manufacturing more of it.

Money 2.0, Electronic Money

Money 2.0, virtual money, is an electronic entry in a ledger. It neither has to be physically delivered nor physically manufactured.

Money 2.0 can be transferred instantaneously, created instantaneously, and the supply of Money 2.0 increases and decreases largely independent of the government.

The amount of virtual money in an economy changes from day to day, month to month, without much government intervention according to the activity in the economy. Essentially, an expanding or contracting economy breathes money in and out like a human being breathes air.

The Money Supply Increases & Decreases On Its Own

If you have a physical asset, land, worth a million dollars, you can go to the bank, sign a few papers, get a half million dollars of Money 2.0 as an entry in an electronic ledger.

Based on that $500,000 deposit, the bank can lend $450,000 to me. So, while last week you had land worth a million dollars, this week you have land with a net worth of $500,000, a bank account worth $500,000 and I’ve got $450,000 in loan proceeds.

By simply borrowing half a million dollars and depositing it in the bank, the money supply has increased by $450,000.

If I deposited that $450,000 in another bank it could loan out $405,000, and so on and so on, with each new deposit generating a new loan and creating an additional increase in the money supply.

And it works the same way in reverse. If you take that $500,000 out the bank and bury it in your backyard, the bank will have to call in $450,000 in loans.

And if the business I started with that $450,000 loan should go bankrupt then that $450,000 would disappear from the money supply.

Money 2.0 is more than a medium of exchange, more than just a form of portable wealth. Money 2.0 is itself a dynamic component of a functioning economy that increases in good times and shrinks in bad times.

Money 2.0 powers an economy like blood nourishes a living body. The larger the body the more blood it needs.

The larger the economy, the more money it needs.

A Metaphor For The Relationship Of Money To Wealth

If you would like to use a metaphor to understand the relationship between physical wealth, money, and the money supply:

  • Think of physical wealth — land, houses, cars, diamonds, whatever — like various sizes and shapes of balloons. The bigger the balloon, the more that asset is worth. The smaller the balloon, the less that asset is worth.
  • Think of Money 2.0 as the air that inflates those balloons. More air, bigger balloon, higher value.
  • Think of the economy as a huge system of pipes and tanks that transport and store the air (money) that fills all those balloons (items of physical wealth).
  • Think of all the air in those pipes and tanks as the money supply.

You have a house, a physical item of wealth that contains a certain volume of air, which air represents the house’s equivalent value in money.

Converting some of the wealth in your house from a fixed, physical item of wealth into money, a portable, interchangeable form of wealth, is like pumping some of the air out of your house balloon through the economy’s pipes and into a tank at your bank.

From there you can move that air through the pipes of the economy, send some of it to a car dealer who pumps it into a new car balloon, send some of it to the credit card company or the college that is educating your children and add your air to their tanks.

When you repay that bank loan, you’re adding air back into you your house balloon and increasing size and thus its net value.

When Values Decline

If your neighborhood goes into decline and home values fall, it’s as if the pipe from your home into the economy has experienced a drop in pressure and sucked some of the air out of your house making your balloon smaller, less valuable.

If your house burns down and you have no insurance, it’s as if your house balloon was massively punctured and all the air, the value, leaked away and disappeared.

When Values Increase

On the other hand, if your neighborhood becomes more desirable and home values increase, it’s as if the pipes connecting your house to the rest of the economy gained pressure and extra air flowed into your house balloon making it bigger (more valuable).

All over the country, as the economy grows or declines, some wealth balloons get bigger, gaining more air, while others get smaller and lose air. The pressure in the pipes is constantly readjusting itself, re-balancing the country’s money supply against the country’s physical forms of wealth.

That pressure and the total volume of air in the system is the country’s total money supply.

When the economy is booming, the banking system pumps more air, more money, into the pipes and when the economy is in recession, money, air, leaks out of the system and disappears.


A material, system-wide increase in air pressure that pumps up the volume of air in all the balloons is inflation.


If land is contaminated, factories close, businesses go bankrupt, their supply of air (money) leaks away and disappears and the money supply decreases, and if that decrease is severe enough we have a system-wide drop in prices, deflation.

As The Country Gets Richer, The Money Supply Has To Get Bigger

If lots of new balloons are added to the economy — new houses are built, new factories are opened, new products are created — the supply of air in the system needs to increase so that it can maintain the same air pressure in the face of all these additional balloons that have sucked air out of the pipes.

The economic system strives to increase the money supply in order to keep all the pipes at the same pressure in spite of the fact that there are lots more balloons that need to be filled than there were before.

The money supply increases through banks lending more money or the government spending more money than it takes in.

The volume of air, the size of the money supply, varies depending on the vitality of the economy, the wealth of the country, government spending in excess of tax revenues, and the number of people in the country.

[**See the sections at the end of this column that illustrate why, in order to maintain stable prices, the money supply needs to increase with an increase in population and increase with an increase in physical wealth.]

How The Federal Reserve Adjusts The Money Supply

The central bank, the Federal Reserve Bank, is constantly trying to adjust the volume money in the system by increasing or decreasing the interest rate it charges banks for the money the banks borrow from the Federal Reserve to loan to their to customers.

If the money supply needs to be increased the Federal Reserve reduces the interest rate it charges banks in the hope that banks will lend more money which additional lending will increase the money supply and spur the economy.

If the Federal Reserve fears that the money supply is too great and that the amount of money in the system is out of balance with the amount of wealth and the number of people in the country, thus potentially causing inflation, the Fed increases the interest it charges on loans to banks so that the banks will lend less money, decrease the money supply, and slow down the economy.

If you think of the economy as a vast system of pipes, tanks and balloons that are constantly being pressurized with more or less air (money), where air is constantly leaking away in some places (bankruptcies, natural disasters, stock crashes) and being pumped up in other places (new products, huge new demand, expanding businesses, stock and land booms), you can get a feeling of how money transfers wealth through an economy.

The system is constantly trying to stay in balance without an increase or decrease in air pressure, without making all the balloons larger (inflation) or all the balloons smaller (deflation).

The relatively minor adjustments through the Federal Reserve’s interest rate changes cannot correct for events that drastically affect the money supply — stock market crashes, depressions, wars, and pandemics.

Those huge disasters are the like burst main pipes that bleed massive amounts of air from the entire system — a massive drop in pressure that affects the whole system.

When huge numbers of wealth balloons all across the country either shrink or deflate entirely, people lose their homes, businesses go bankrupt and the economy falls into a recession or a depression.

How do you fix that?

When The Money Supply Drastically Shrinks

Let’s say that because of a pandemic the economy stops, a very large number of businesses are closed and a third of the population is suddenly out of work while all the costs of living still remain; people still have to eat.

For a while people are able to pay their rent and buy food with their savings, but eventually all their savings are gone. Because no one has any income or savings left, they can’t get money by selling their assets because no one as the money to buy them. That means that their houses, their cars, their jewelry cannot be converted from physical wealth to virtual wealth because almost no one has any money left to buy anything they don’t absolutely need in order to survive.

The banks don’t have any money because everyone has withdrawn whatever savings they had and this loss of deposits has caused the banks to call in their loans which no one has the money to pay.

Landlords don’t have any money because people have stopped paying rent. Businesses can’t function because they have no money to pay workers or buy materials.

Without money being available to transfer wealth between buyers and sellers, employers and employees, everyone who can’t raise their own food will eventually starve. Even if you had some physical money, it wouldn’t do you much good because with the factories shut down the shelves will be empty and there will be nothing left to buy.

The supply of money has drained away and without it, the economy has died. In cases like this, economists sometimes say that the economy has become frozen.

The physical country is the same. The land is still there. The buildings are still there. The factories and stores are still there, but everyone is bankrupt and starving because the economy has run out of money.

It’s as if all air has leaked out of massive ruptures in the pipes, and any physical money that may still be around will be next to worthless because there is little left to buy with it.

An economy without money is like a car without fuel, like a human being without blood.

You cure the dying human by transfusing him/her with more blood.

You fix the frozen economy by replacing the money that has disappeared, by restoring the money supply to the value it had before the crash or pandemic.

When Creating More Money Causes Inflation And When It Doesn’t

Increasing The Money Supply In A Stable Economy

If the economy is reasonably stable and prosperous there is a balance between the money supply (portable wealth), and things (physical wealth).

Materially increasing the money supply in a stable economy when there has not been a proportionate increase in the physical wealth will result in each unit of money being able to purchase a smaller quantity of physical wealth.

More dollars, same amount of things to buy with them, each dollar buys fewer things.

Drastically increasing the money supply that had been in balance with the amount of physical wealth so that the money supply is now seriously out of balance with the country’s physical wealth will cause an increase, an inflation, in the dollar value of those items of physical wealth in order to match the new, larger supply of money.

Restoring The Money Supply In A Depressed Economy

On the other hand, if there has been a substantial decline in the money supply because of a depression or a pandemic, then returning the money supply to its previous level will not cause inflation because you are returning the money supply back to the prior balance that existed between it and the country’s physical wealth before the decline.

If you know that the economy has lost twenty-trillion dollars in a depression you not only can add twenty-trillion dollars back into the money supply without increasing prices above the level they were at before the depression, you need to add twenty-trillion dollars to the economy in order to return the economy to the healthy condition it was in prior to the depression.

The Pandemic Is Expected To Cost The U.S. Economy $8 Trillion

The Congressional Budget Office estimated that over the next ten years the Covid-19 pandemic will cost the U.S. economy about $8 trillion, or an eight trillion dollar loss to the money supply.

That means that the money supply will be need to be increased by approximately $8 trillion in order to just get the economy back to where it was prior to the lockdown.

Put differently, the government can spend $8 trillion more than it collects in taxes without causing a material increase in inflation.

— David Grace (www.DavidGraceAuthor.com)

An Example Of Why The Money Supply Needs To Keep Pace With Changes In Population

Suppose a religious group of 1,000 people founded a community out in the wilderness. Because they believed in wealth equality each person was given 100 coins arbitrarily valued at $1 each for a total money supply of $100,000.

Some of the members bought cotton and flax, spun thread and wove towels which they sold for $10 each. Everyone bought a towel and everyone had 90% of their money left over to spend on other things.

Years went by and the community increased to 10,000 people. If the money supply was not increased to keep pace with population growth, there would now still be a money supply of $100,000 divided among 10,000 people or $10 each. If people were still going to spend 10% of their money on a towel the price of a towel would need to fall from $10 to $1, a price deflation.

On the other hand, if the elders had gifted every new member with 100 coins when they reached a certain age, the money supply would have increased to 10,000 people X 100 coins each = $1,000,000. Everyone would still start out with $100, towels would still cost 10 coins and there would be no inflation or deflation even though the government increased the money supply by 1000%.

In other words, in order to keep prices stable in the face of a 10X population increase, the money supply also had to be increased by 10X.

An Example Of Why The Money Supply Needs To Keep Pace With Increases In Wealth

Suppose you have a prosperous, stable economy where the country’s physical wealth is in balance with its money supply so that there is little inflation or deflation.

A group of physicists figure out how to tap into dark energy and they design a machine about the size of a small truck that can product a megawatt of electricity without any fuel by directly tapping into dark energy.

Since the U.S. consumes about 4 trillion kilowatt hours of electricity, the country would require about four million of these devices at the cost of a million dollars each or $4 trillion dollars. Add in the costs to provide additional electricity to desalinate sea water and crack hydrogen out of water for fuel-cell cars and trucks, plus the capital costs to build the factories, train the workers, etc. let’s say that it would cost at least $10 trillion to switch the country to this new “free” electricity.

That’s an amount far beyond the capacity of the private banking system so the government increases the money supply by loaning the new company ten trillion dollars which it creates out of thin air by just creating a bank account with ten trillion electronic dollars in it.

Because the new ten trillion dollars in money will be balanced against the new ten trillion dollars in power production infrastructure, plus the vast increase in the country’s wealth from irrigating millions of acres of once worthless, arid land with desalinated sea water, and all the trickle down benefits of the new industries and cheap power that will flow from this loan, the ten trillion dollar increase in the money supply will be more than balanced against the new physical wealth that the loan created.

Since the increase in the money supply will be more than offset by an equal or greater amount of physical wealth the increase in the money supply would not cause inflation.

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