Academic journal article Economic Inquiry

The Long-Run Link between Money Growth and Inflation

Academic journal article Economic Inquiry

The Long-Run Link between Money Growth and Inflation

Article excerpt

I. INTRODUCTION

Post-war U.S. inflation has fluctuated considerably. This variability in inflation has generated a large literature on the causes and effects of inflation. There is little doubt that volatile inflation affects the real economy through increased risk and adjustment costs.(1) Recently, several authors have found evidence that the inflation process itself is unstable, in the sense that shocks to the inflation rate are not completely eliminated over time. The implication is that the long-run variance of the inflation process is infinite. Given the real effects of inflation instability, it is important that we have an understanding of the source of that instability. Two broadly defined possibilities of that source are nominal and real.

A standard result of most textbook macroeconomic models which include money and prices is that changes in the money supply lead, eventually, to proportional changes in the price level.(2) According to this class of models, any long-run instability or unit root in the inflation process can theoretically be traced to a unit root in the money supply growth rate. This proposition has led to a debate on the desirability of rules versus discretion in setting the money supply growth rate. The monetarist argument is for a constant growth rate rule. Under such a policy, activist monetary policy would be eliminated. The benefits from such a policy are derived from the reduction in uncertainty associated with the money growth rate. The costs result from an inability on the part of the monetary authority to practice stabilization policy. Where one ends up on this debate is not only dependent upon one's view of the efficacy of monetary policy, but is also dependent upon the source of the unit root in the inflation process. Ira real source is identified, a policy rule may not be optimal, assuming policy is effective at mitigating the effects of these real shocks, though perhaps only in the short run. Alternatively, if nominal shocks are the source of the inflation unit root, then a policy rule of constant money growth may lead to a welfare increase through a reduction in the risk and adjustment costs associated with inflation.(3)

The relationship between money growth and inflation is a basic one. But, like the relationship between money and income, alternative causal orderings are consistent with plausible theoretical restrictions. For example, within the real business cycle literature, there has been a recent focus on introducing nominal variables into the artificial equilibrium growth economies.(4) In this class of models, a unit root in the inflation rate may be due, at least theoretically, to innovations in the real variables such as transactions technology and productivity. In a bivariate model of money growth and inflation, then, one may observe that inflation is the proximate source of the unit root in money growth while real output may ultimately be the actual source.(5) Similarly, long-run causality from price inflation to money growth may exist due to accommodating monetary policy or inflation targeting on the part of the monetary authority.

The empirical evidence to date, although casual, seems incontrovertibly in favor of the nominal cause paradigm, especially for hyper-inflationary economies. This may result from the nominal effects of the money growth rate process dominating the real effects, and may not be a good representation of the same causal direction in the U.S. economy. Formal analyses of the long-run causality of money/prices is sparse, especially for moderate inflation economies like the U.S. Friedman and Schwartz [1982] provide a simple analysis of the correlation between U.S. money and prices over a span of more than 100 years. Hallman, Porter and Small [1991] provide evidence of a long-run link between M2 and the price level. The methodology used in both of these studies is quite different from that used in the present study. Each concludes that their results support the standard monetarist proposition that changes in money "cause" changes in the price level. …

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