It’s important, I think, that I occasionally remind readers of a fact that is supported by overwhelming quantitative evidence, and yet virtually ignored by a wide majority of economists (and central bankers): inflation is a consequence of the stock of money growing faster than real economic growth. Period.
MV=PQ
That doesn’t mean that forecasting inflation is easy if we remember that fact, but at least we can make good directional predictions when, say, the stock of money rises 25% in a year, instead of mouthing some nonsense about inflation in such a case being “transitory.”
However, I realize that when someone mentions that equation a lot of people tune out, thinking this has become a religious argument between monetarists and Keynesians. So let me toss out some data. Keep in mind, that there is measurement error in statistics for the money supply, real GDP (especially), and prices.
As I’ve written before, sharp changes in M can cause a short-term impact on velocity until Q and P can catch up – my ‘trailer attached by a spring’ analogy. But over time, a shock move in velocity becomes less important (and reverses, which is what we are in the middle of), and so we would expect by simple algebra to see that a good prediction of the change in the price level is given by M/Q. Is it?
First, let me share one of my favorite charts from a Federal Reserve Economic Review. I’ve been using this for years.
This is over 5-year periods, and you can see that there’s a pretty good correlation – especially for large changes – in the change in the ratio of money/income and the change in prices. (By the way, the original article is still worth reading).
Here is another chart from that note, updated by me through the end of 2022.
The fact
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