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The Problem With Monetism

Posted By on February 12, 2009

The Quantity Theory of Money says that inflation is the difference between the growth rate of money, and the growth rate of the real economy.  Adding more money increases inflation (or decreases deflation), but has no effect on real GDP.  Inflation, in other words, is a function of the money supply.

Monetism predicts that:

Inflation  = growth of money – change in real GDP.

Which is the same as:

Growth of money = inflation + change in real GDP.

Because the sum of inflation and the change in real GDP is the definition of nominal GDP growth, QTM also says that the change in the money supply is equal to the change in nominal GDP.  While real GDP can’t be directly observed (it’s the product of nominal GDP and the GDP deflator, or, nominal GDP minus inflation), nominal GDP and inflation can be.

Put this way, Fed statistics don’t seem to support the Quantity Theory of Money.

The following charts are all constructed using FRED, the Fed’s sweet charting program (try it, it’s fun).

MZM (money of zero maturity) vs. Nominal GDP

MZM (money of zero maturity) vs. Nominal GDP

MZM is money of zero maturity.  It means money that’s immediately available at par value (1:1 basis).  It includes M2 and money market funds, less time deposits.

M2 v. Nominal GDP

M2 v. Nominal GDP

M2 is M1 (currency and checking accounts), plus savings accounts, money market accounts, and small deposit CDs (less than $100,000).

Money Base v. GDP

Money Base v. GDP

Base money, or monetary base, is currency plus bank reserves.  In other words, it’s the liabilities of the central bank.  (You should be able to click on this for a bigger image.  The recent spike makes the rest of the chart hard to read.)  QTM predicts a lot of inflation coming up, at least if it’s based on the Fed’s balance sheet.

Monetary theory doesn’t say which measure of money supply should be used to predict inflation.  There doesn’t seem to be a particularly strong correlation with any of them, however, at least on a year-to-year basis, over the last thirty to fifty years.

They all do share one commone attribute, which is a moderate, positive rate of growth over the long term.

The same can be said about a number economic measurements, however.  The rate of increase of credit card debt among farmers, for example, is correlated to GDP, in the sense that they both have a moderate, positive rate of growth, over the long term.

The results from economists doing sophisticated comparisons of long-term correlations between inflation and money supply have been mixed.

De Grauwe and Polan, for example, found that “a higher growth rate of money does not lead to a proportional increase in inflation in the long run,” among developed countries, like the US and Japan.

Money growth, on the other hand, had a more than proportional effect among high-inflation countries.  In other words, adding money to poor economies created more inflation than it should have.

In Japan, base money almost tripled from 35.8 trillion yen in 1989 to 96.6 trillion yen in 1996, while CPI increased by only about 10%.  Inflation was negative in Japan between 1999 and 2005, while the its central bank added about 50 trillion yen.

Thorsten Polleit compares inflation and money supply directly, arguing there’s “a relatively close relationship between money growth and consumer price inflation.”

"Why Money Supply Matters"

"Why Money Supply Matters" Thorsten Poillet, 2005.

The correlation coefficient, he says, is .20 for 2 year averages, and .71 for 6 year averages.

What’s interesting though, is that the falling inflation rate of the 1980’s precedes the later decrease in the money supply.  Monetary theory predicts it should be the other way around – that the money supply should control inflation, not that inflation should control the money supply.

Central bankers themselves, supposedly, pay little attention to the money supply.  Which is strange, considering QTM appears to be the central theory of inflation among economists.  It’d be a bit like engineers ignoring the theory that force equals mass times acceleration, had such a thing ever happened.


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