What Happens When Governments Pump In Large Sums Of Money As Stimulus

The other day, a friend sent me a video showing the physical printing of large amounts of US dollars. Accompanying this video, my friend exclaimed that the US was able to freely do so with little or no consequence. The printing of money was the equivalent of the approval, if ever, of the large stimulus package sought by the new US President Biden. In  making this statement, it is apparent to me that many people do not really understand the effects of the stimulus on the currency.

In any country, its wealth does not change overnight, only very gradually. To simplify matters, let us assume that money only comprises the currency. Of course in real life, there is M1, M2 and M3 money supplies which greatly complicates the issue. For the purpose of this blog, readers should consider that the other forms of money comprises bonds, financial instruments and deposits in financial institutions which we will ignore.

With this assumption, say the country prints an additional amount of currency that has the same value as the total currency in circulation. Since the wealth of the country cannot change immediately with this additional amount of currency, the effect is that the value of this currency is halved. Halving the value of the currency with twice the amount of it in circulation effectively maintains its aggregated worth, thus retaining the amount of wealth the country has.

In  response to stimulus approval, traders would bid the value of the currency down. My friend queried as to how traders would know the amount of currency in circulation to know the amount of dilution. In practice, this knowledge is not neccessary. The stimulus would create an excess amount of currency which other traders would be keen to trade to preserve the capital. The larger the stimulus, the more the amount would be available for trading. Thus, the excess supply would create a downward pressure on the value thus resulting in its defacto depreciation. In the earlier hypothetical case, the additional amount of currency was equal to the total value of the currency in circulation. The end should result in a depreciation of the currency by half. However in practice, it does not mean that the value of the currency would fall exactly to half its value before the additional amount is printed. Currency value is dynamic and prices fluctuate rather than move in a straight line. As economic reports come on stream and the world too changes, the value would be erratic. However the trend towards half its previous value would be unmistakable.

As to my friend’s point that that the US bears no consequences in printing large sums of money, this is not correct.  The large stimulus would result in a higher debt burden for the country. In extreme cases, a large debt in a country could result in a default like what happened to Argentina many times and as recently as 2001. However the US is not in danger of such a default. What happens is that investors and traders would factor in the larger debt and adjust the value of the currency according, given the lower value of the net worth.

Given that there is not much consequence in the US for increasing its debt, the question remains as to why many developing countries are wary of increasing their debt levels. The argument above suggests that the only effect these developing countries would have is a slight depreciation to their currency. However, these developing countries are already facing doubts about their abilities to service their debts. Thus any additional debt would result in a further deterioration of their sovereign ratings, thereby raising the interest rates that they have to pay for the sums that they need to borrow.

In today’s Covid-19 stricken world, many other countries in addition to the US have pumped in lots of money to boost their flailing economy. Thus the effect any stimulus may have on the value of the currency of the country would be mitigated by similar moves in other countries. Its like if all countries depreciated their currencies by the same percentage, then the effect would be their values would be unchanged.