Inflation: Part 2

Who Creates Inflation?

Hello friends,

In Part 1 of this series, we explored what inflation is and why it matters. We learned that inflation is the gradual decline in the purchasing power of money. While most people recognize inflation through rising prices, the deeper question remains:

Where does inflation actually come from?

This question has been debated by economists, politicians, central bankers, and investors for generations. The answer is not always simple because inflation can be influenced by many factors, including supply shortages, natural disasters, wars, and shifts in consumer demand.

However, when discussing long-term inflation, one factor stands above all others: the expansion of the money supply.

To understand this relationship, we must first understand how money enters the economy.

Many people assume that the federal government simply prints money whenever it needs more. While there is some truth to that perception, the modern monetary system is far more complex. In the United States, money creation involves a relationship between the U.S. Treasury, the Federal Reserve, and commercial banks.

The U.S. Treasury is responsible for managing government finances and issuing debt when spending exceeds tax revenue. The Federal Reserve serves as the nation's central bank and plays a critical role in managing interest rates, providing liquidity, and maintaining financial stability. Commercial banks then expand the money supply further through the lending process.

This is where things become interesting.

When a bank approves a mortgage, business loan, or line of credit, it is not necessarily lending existing money from a vault. Through the modern banking system, new deposit money is often created when loans are issued. As lending expands throughout the economy, the overall money supply grows.

This process has been occurring for decades.

At the same time, governments frequently operate with budget deficits, spending more than they collect in taxes. To finance these deficits, additional debt is issued. Over time, this creates a financial system where debt and money creation become closely connected.

As more money enters the economy, the number of dollars competing for goods, services, and assets increases. If the supply of products does not grow at the same pace as the money supply, prices tend to rise.

Imagine a small town with one hundred homes and one million dollars circulating among its residents. If the amount of money suddenly doubles while the number of homes remains the same, buyers now have more dollars available to compete for a limited number of properties. The result is often higher prices.

The same principle applies throughout the broader economy.

This does not mean that every increase in prices is caused by money creation alone. Temporary inflation can occur when supply chains break down, energy prices spike, or shortages develop. We witnessed examples of this during the COVID-19 pandemic when supply disruptions affected industries around the world.

Yet history shows that sustained inflation over long periods is closely tied to the growth of the money supply.

This reality creates a challenge for savers.

When more dollars are created over time, each existing dollar tends to represent a smaller share of the overall monetary system. As a result, money held in cash may gradually lose purchasing power unless it is earning returns that exceed the rate of inflation.

For investors, understanding this concept is important because it changes how we view wealth. Wealth is not simply the number of dollars we possess. Wealth is what those dollars can purchase.

A bank account may contain the same balance it held five years ago, but if housing, food, healthcare, and transportation costs have increased significantly, the purchasing power of that balance has declined.

This is one reason many investors choose to own productive assets rather than hold excessive amounts of cash. Businesses, real estate, dividend-producing investments, and other assets often have the ability to grow in value or generate income over time. While no investment is guaranteed, productive assets have historically offered a better opportunity to keep pace with inflation than idle cash alone.

Understanding who creates inflation is not about assigning blame. It is about understanding how the modern financial system operates. Once we understand the relationship between money creation and purchasing power, we can make more informed decisions about saving, investing, and protecting our financial future.

In Part 3, we will examine why inflation is often called the hidden tax and how it affects workers, retirees, savers, and families across America.

Until next time, stay consistent, keep learning, and continue building your path toward cash flow, growth, and long-term financial success.

Samuel F. Lilly

Founder, MoveOn LLC™

Creator of The Consistent Investor™ and the 50/35/15™ Framework

Disclaimer: This newsletter is provided for educational purposes only and should not be considered financial, investment, tax, or legal advice. Always conduct your own research and consult qualified professionals before making financial decisions.