I think I posted something about a year ago on this same topic but I don't have time to look. In our modern system, money is the same as debt. When you borrow money from a bank, the bank actually creates the money to lend to you. However, this isn't inflationary in the long run because as you pay back the loan the debt is extinguished. If you don't pay it back, this is a different issue, but the interest the banks earn covers the bad debts (unless there are massive defaults).
The same is true when the Federal Reserve buys bonds on the open market. Yes they are creating the cash to buy the bonds with, but as the bonds are repaid, the money is destroyed. They are just exchanging one type of money - negotiable bonds - for another type - bearer notes (FRNs).
With the government, it is a different story. When the government deficit spends, it creates money. Surpluses have the opposite effect but they are very rare. To determine how much inflation is created, first measure the actual amount of money in the system. Take M2, add the national debt, and subtract the debt owned by the Fed.
I don't have time to run the actual numbers, but suppose that on 9/30/2011, M2 was 9 trillion, the nation debt was 15 trillion, and the amount of debt owned by the Fed was 1.5 trillion. Thus the total money supply is 22.5 trillion. Now, one year later, if M2 is 10 trillion, the national debt is 16 trillion, and debt owned by the Fed is 2 trillion, then the total is 24 trillion. The rate of monetary inflation would thus be 6.7%. It would be interesting to see what these numbers are.
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Update: I think that the Fed buying bonds of Fannie Mae and Freddie Mac is fundamentally different than them buying US Treasury bonds. T-bonds are like cash, were exchanged for cash, and have the full faith and credit of the US. Bonds of Fannie and Freddie are backed up by dodgy assets. Yes Fannie and Freddie are owned by the US government, but their debt is backed up by mortgages, not the US government, except as a backstop. So rule #2: when the Fed buys up non-Treasury debt, it creates money. (This doesn't show up directly, but is included in the M2 amount).
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Here are the numbers as of 9/30/2012:
M2 (as of 9/24/12): 10123.0
Nat. Debt (as of 9/28/12): 16066.2
Less Owned by Fed (as of 9/27/12): 1643.2
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Total Money Supply: 24546
I am being very specific as to the dates because I want to use this as a benchmark.
This will be an interesting number to watch. I would apply the same rule-of-72 criteria to this. It should not increase by more than 7.2% per year, (thus doubling every 10 years) or else there is a danger of inflation getting out of control. So this number should grow by no more than 1768 bn/year (147 bn/mo).
This accounts for the two ways that money is created: 1) through deficit spending, and 2) through Fed purchasing non-Treasury assets. (There is also a third way that money is created, through private bank lending. This is included in the M2 total. But as mentioned above, money is destroyed when loans are paid off, so the net effect should be zero.). If you think about the national debt being just part of the growing money supply that is needed for a growing economy, then there is no problem, unless it increases excessively. The Fed's latest actions can be seen as being the same as a private bank making a new loan using agency debt as collateral.
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As of 9/30/2011:
M2: 9500.2
Nat. Debt: 14790
Less Owned by Fed: 1663.6
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Total: 22627
Increase from 9/30/2011 to 9/30/2012: 1919
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The GDP on 9/30/2011 was 15181.
The estimated GDP on 9/30/2012 is 15693. (This is a projection. The BEA will release the preliminary figures later this month.)
So the nominal GDP increased $512 bn.
The ratio of the increase in total money supply to increase in GDP is 3.75. This is a very disturbing number - it doesn't need to be more than 1.0. There is plenty of money, that is why the M2 Velocity is so low. The Fed is still trying to push on a string.
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