Money and Inflation: Some Critical Issues

Abstract

We consider what, if any, relationship there is between monetary aggregates and inflation, and whether there is any substantial reason for modifying the current mainstream mode of policy analysis, which frequently does not consider monetary aggregates at all. We begin by considering the body of thought known as the "quantity theory of money." The quantity theory centers on the prediction that there will be a long-run proportionate reaction of the price level to an exogenous increase in the nominal money stock. The nominal homogeneity conditions that deliver the quantity-theory result are the same as those that deliver monetary neutrality, an important principle behind policy formulation. The quantity theory implies a ceteris paribus unitary relationship between inflation and money growth. Simulations of a New Keynesian model suggest that we should expect this relationship to be apparent in time series data, with no heavy averaging or filtering required, but with allowance needed for the phase shift in the relationship between monetary growth rates and inflation. While financial innovation can obscure the relationship between monetary growth and inflation, evidence of a money growth/inflation relationship does emerge from U.S. time series and G7 panel data.Various considerations suggest that studies of inflation and monetary policy behavior can benefit from including both interest rates and money in the empirical analysis.

Time Aggregation and the Relationship between Inflation and Money Growth

“…Our first explanation alters the true model from the previous section by incorporating lags of . This approach is most closely identified with the work of McCallum and Nelson (). The true model is now Equation says that inflation is determined by a distributed lag of money growth with lags.…”

“…Sargent and Surico () find that the unitary elasticity hypothesis breaks down in the United States when monetary rules are introduced. Using a distributed lag model, McCallum and Nelson () find qualified support for the unitary elasticity of money growth for the United States. They also test proportionality for the G‐7 countries and find little support.…”

The Swings of U.S. Inflation and the Gibson Paradox

“…Hence, the nominal money per capita growth rate μ t is also included as observable, which is computed using the log difference of “Money with Zero Maturity” (MZM), reported by the Federal Reserve Bank of St. Louis and already used in the VAR estimation carried out above. As discussed in McCallum and Nelson () and Altig et al (), there are hybrid definitions of money such as MZM or Divisia more adequate for providing a representation of the medium‐of‐exchange role of money than more conventional aggregates such as the Monetary Base, M1 or M2…”

Has U.S. Monetary Policy Tracked the Efficient Interest Rate?

“…A chart with a range of estimates of this rate is included in most published Bluebooks at least since May 2001. According to McCallum and Nelson (2011), this construct emerged in the early 1990s at the Federal Reserve as a gauge of the monetary policy stance following a shift of emphasis away from monetary aggregates, due to the difficulty of estimating a non-inflationary growth rate of money in the midst of financial innovation. See also Amato (2005).…”