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How and How Much Can the Money Supply Affect the Inflation Rate?

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How and How Much Can the Money Supply Affect the Inflation Rate? Money Supply and Inflation How and how much can the Money Supply affect the Inflation Rate? Amedeo Strano Abstract The relationship between inflation and money growth has been tested for the Iceland over the period 1972 - 2002 then using a sample of 11 countries over the same period we test for the quantity theory relationship between money and inflation. When analysing the full sample of countries, we find a strong positive relation between long- run inflation and the money growth rate. There is a strong link between inflation and money growth both in the high- (or hyper-) inflation and low-inflation countries in the sample (on average less than 10% per annum). Keywords: Inflation; Money; Quantity theory of money JEL classification: E40; E50 1 1.1 Introduction In recent years money supply increased rapidly and some researchers thought this increase in money supply was going to translate quickly into inflation. But inflation did not grow much and empirical evidence shows that shocks to the petrol and meat supply mainly affected inflation. In the long-run the relationship between money supply and price is very strong and their correlation is almost one. Lucas (1995) emphasized the long-term relationship between money and prices in his Nobel Prize lecture by mentioning McCandless and Weber (1995). For the short-term relationship, empirical evidence of relationship between money growth and inflation is weak and unclear. A variety of studies on money demand yield very dissimilar results. As result, it is difficult to establish a straight relationship between these two variables in the short-term. This paper tries to measure the relationship between money growth and inflation for Iceland and a sample of ten different countries. 1.2 The Monetary View In the long-run the relationship between inflation and money growth depends on the demand for money and money supply. Central banks affect the money supply through their policy actions such as buying and selling government securities, changing reserve requirements, or changing the interest rate at which the central bank provides reserves to financial intermediaries. The public’s demand for money is another important part of the relationship between money growth and inflation. If M is the nominal quantity of money and P is the price level, the real quantity of money is M/P. The price level commonly is measured by general price indexes such as the consumer price index and the gross domestic product deflator. The most important factor affecting the demand for money is real income and this relationship can be written as: = where y is real income and k is the other factors. Other factors include the opportunity cost of holding money or the forgone interest income from holding money instead of other assets. In addition other factors also can affect the demand for money, such as payments practices and technological innovations in financial intermediation. 2 If the nominal quantity of money supplied equals the quantity demanded, from the previous equation, price equation can be written as: =−1 If real income were constant and other factors did not affect the demand for money or were constant, then there would be a proportional relationship between the price level and the nominal quantity of money relative to real income. In other words, growth rate of money supply would be equal to the inflation rate. Monetarism has three essential features (Meyer 2001). First, monetarism is the reincarnation of classical macroeconomics, with its focus on the long-run properties of the economy rather than short-run dynamics. Second, monetarism focuses less on the structure of the economy and this is related to the skepticism about our ability to understand or to adequately quantify the structural linkages and dynamics. Third, monetarists are skeptical of the ability to use monetary policy for short-run stabilization, despite the fact that they believe short-run variations in money growth do affect aggregate demand and hence output. As a result, they favor rules that focus on achieving a rate of money growth consistent with price stability in the long run. Noted economist A. Meltzer (1998) said most working economists, most central bank staffs, and market practitioners do not use money growth to predict inflation. Many rely on the Phillips’ curve or atheoretical relations. Although in the long-run there is strong correlation between money growth and inflation, monetary policy makers do not use long-run relationship because this relationship disappears in the short-run. 1.3 The Theory Any increase in expenditure which cannot be met by an increase in output (or in imports) will result in a rise in prices, and the view that an increase in expenditure will lead to a change in price rather than quantity is, like the view that people want money only in order to spend it, a very long-established view in economics. The most common expression of this is in the equation of exchange: MSV = PT Where: - MS is the money stock; - V the velocity of circulation or the number of times the money stock changes hands per period of time; - P is the average price of goods and services; - T is the number of transactions per period of time. 3 It is customary to point out immediately that this is an identity or truism since MS x V (the total of spending) must be equal to P x T (the total of receipts). In itself this is of no interest to us. V was regarded as fixed by custom or convention. If, on the left-hand side of the equation, MS increases, expenditure will rise because people's willingness to spend the money is fixed. On the right-hand side, T, the volume of transactions, will depend upon the quantity of goods and services bought and sold. This is taken to mean that it depends upon the quantity produced, though this assumes a constant relationship between total transactions and transactions involving newly pro- duced goods and services. Thus, the transactions symbol (T) is often replaced by output (Y). This was traditionally treated as fixed because it was argued that the economy tended always to 'full employment' (though little thought was given to what was meant by the expression). The argument was that people would prefer to work rather than not work and that the force of competition for jobs would produce that level of real wage at which everyone could be profitably employed. With V and T constant, a change in MS will produce a proportional change in P. It can be seen that we have combined the following two propositions: - A change in the money stock will always produce a proportional change in expenditure, i.e. velocity is fixed. - A change in expenditure will lead to a change in the price level rather than in the quantity of output. This produces the basic monetarist conviction that a change in the money stock has its influence mainly upon the price level. Schematically, we have: ∆MS ∆Expenditure ∆P (a) (b) Link (a) arises because velocity is fixed; link (b) because output is fixed. 4 2.0 Empirical Results 2.1 Regression Analysis, Iceland In the graph 2.1a has been plotted the scatter diagram of the ∆ Money Supply against the Inflation, the result has been a straight positive trend-line tending to the top-right with a low level of discrepancy, having a look to the math we can do further consideration. 2.1a Inflation Versus Money Growth - Iceland 70 60 y = 0.9446x - 2.4554 R² = 0.6796 50 40 Changes In Money Supply And 30 Inflation In Iceland TrendLine Inflation Rate % Rate Inflation 20 10 0 -10 0 10 20 30 40 50 60 70 -10 Money Growth Rate % The R square is the coefficient of determination, the value of R lies between 0 and 1, the closer the value of R is to 1 the better the fit of the data to the model. The data taken in analysis show a medium-high value of correspondence between the ∆ Money Supply and the Inflation: 0.67955956, the value is not very close to 1, 67.96% of the variation in the dependent variable can be explained by the variation in the ∆ Money Supply. 2.1ln SUMMARY OUTPUT Regression Statistics Multiple R 0.824354026 R Square 0.67955956 Adjusted R Square 0.668115258 Standard Error 9.584193167 Observations 30 5 ANOVA df SS MS F Significance F Regression 1 5454.429767 5454.429767 59.37973261 2.14902E-08 Residual 28 2571.989242 91.85675866 Total 29 8026.41901 Coefficients Standard Error t Stat P-value Intercept -2.455436735 3.404857196 -0.721157039 0.47679171 0.944629907 0.122586479 7.70582459 2.14902E-08 (residual output of 2.1ln at the end of the paper) If we would show graphically the function should then be: Inflation = α + βms Given the information acquired from the data in analysis: y = -2.45543673523044 + 0.944629907192597ms - the estimated value for the intercept (α) is -2.45543673523044 - the estimated value for the slope coefficient or variable x coefficient (β) is 0.944629907192597 - ms is given by the ∆ Money Supply that change year by year In the graph 2.1b we can see the discrepancy between the real Inflation experienced in Iceland and the Inflation as result of the function above. - Inflation It shows the real Inflation - Predicted It shows the results of the function according with the value shown in the column predicted of the linear regression 2.1ln. If we have a look to the graph 2.1c, it shows year by year the correspondence between ∆Money Supply and Price Level in the thirty years taken in analysis.
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