Money And Inflation Are Still Related
Summary
- This widespread belief that monetary aggregates are uninformative is incorrect.
- This widespread belief has resulted in governments not estimating monetary aggregates, or else estimating them for a much narrower set of series than in prior years.
- Monetary policymakers and economists in the United States and some other countries would have done better if they had not ignored money growth.
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By Gerald P. Dwyer and John Devereux
“There is perhaps no empirical regularity among economic phenomena that is based on so much evidence, for so wide a range of circumstances,” Milton Friedman observed in 1989, “as the connection between substantial changes in the quantity of money and in the level of prices.” And yet, despite the wide body of work alluded to by Friedman, most monetary policymakers and economists believe that there is no information to be gained by looking at monetary aggregates. This widespread belief has resulted in governments not estimating monetary aggregates, or else estimating them for a much narrower set of series than in prior years. Monetary aggregates make no appearance in many econometric models of the economy, and are rarely if ever brought up in the briefings for Federal Open Market Committee meetings.
This widespread belief that monetary aggregates are uninformative is incorrect.
Figure 1. Excess Money Growth and Inflation in 108 countries, 2008-2022.
The positive relationship between the inflation rate and excess money growth over these 14 years is obvious. A linear relationship with a coefficient of one between inflation and excess money growth is an implication of some theories relating inflation and excess money growth. The correlation of inflation and excess money growth is 0.92. The slope of a line relating inflation and excess money growth is 0.95, when estimated by a regression of inflation on excess money growth.
While not one, 0.95 is not all that far from one. Figure 1 shows a line with the one-for-one relationship and another with the slope of 0.95. They are not all that far apart. Most of the countries in Figure 1 have lower inflation than implied by the excess money growth. This means that the demand for money in these countries increased even more than is implied by the growth rate of real income alone. It does not mean there is no relationship between money growth and inflation.
Figure 2. Excess Money Growth and Inflation in Countries with less than 30 Percent Inflation, 2008-2022.
These correlations show two things:
- The relationship is weaker for countries with lower inflation than higher inflation; and
- The relationship is weaker over shorter time periods.
There is a common explanation for both of these observations. Over shorter periods of time and in countries with relatively low inflation, Mark Fisher and Gerald Dwyer have shown that inflation which is more persistent than money growth can explain both. Inflation is quite persistent as a general rule and money growth less so.
Is the information content of money growth zero? Unequivocally, the answer is no.
Why does this matter?
M2 in 2020 and 2021 increased by the largest percentages in the last 60 years. To the surprise of the Federal Reserve (although not everyone), inflation resulted. Not all countries have increased the money stock to the same extent. Japan and Switzerland have not had outsized increases in the money stock and have not had higher inflation. Monetary policymakers and economists in the United States and some other countries would have done better if they had not ignored money growth.
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