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Money & price level in pooled data: strong correlation for high-inflation countries CPI, 12 m percentage change 80000 70000 60000 50000 40000 30000 20000 10000 0 -10000 All countries π = - 30.6+1.88*μ R 2 = 0.68 0 5000 10000 15000 20000 25000 M1, 12 m percentage change CPI, 12 m percentage change 40 35 30 25 20 15 10 5 0 -5 -10 π = 2.40+0.24μ R 2 = 0.17 OECD 0 10 20 30 40 50 M1, 12 m percentage change Sources: IFS and Reuters EcoWin Hence, for the sample as a whole, inflation and money growth have tended to move in tandem, even on a quarterly basis: changes in M1 growth “explain” 68 percent of changes in inflation. However, focusing on the OECD area, we find at best a weak short-term correlation. Thus, it appears that data for hyper-inflation economies infect the results for the entire sample, illustrating the vicious spiral of the hyper-inflation process: inflation takes off as the money supply explodes, which triggers transactions demand for money, giving another boosts to the money supply, etc. To conclude, money growth is typically not a reliable short-term indicator of economic activity or inflation, at least not for low/medium-inflation economies. Hence, at first glance Milton Friedman was wrong when claiming that “inflation is always and everywhere a monetary phenomenon” since different kinds of shocks to the economy tend to drive a wedge between money growth and inflation. However, a believing monetarist would argue that many of the apparently exogenous shocks affecting inflation are really monetary in kind. For example, a monetarist might argue that the commodity price shock shooting inflation higher in recent years de facto was a reflection of too lax monetary conditions for too long. …but compelling evidence of a strong long-term relation Inflation a monetary phenomenon in the long term Although the relation between money and inflation is unstable in the short term, there is compelling evidence of a strong long-term relation between money and the aggregate price level, although causality is an open question. Money & price level in cross section data: Strong long term relation Average inflation, 1980-2007 1800 1600 1400 1200 All countries 1000 800 π = -15.7+1.64*μ 600 R 2 = 0.95 400 200 0 -200 0 200 400 600 800 1000 1200 Average M1 growth, 1980-2007 Average inflation, 1980-2007 7 6 5 4 3 2 1 0 OECD π = 1.51+0.29μ R 2 = 0.65 2 6 10 14 18 Average M2 growth, 1980-2007 Sources: IFS and Reuters EcoWin Average money growth explains more than 50 percent of inflation differentials According to the upper left graph, differences in average money growth (M1) “explain” 95 percent of differences in average inflation among more than 100 countries since 1980. A simple regression suggests that one percentage point higher average money growth rate “leads to” 1.6 percentage point higher average inflation rate, disregarding the issue of causality. It is clear from the graph that there are some extreme outliers in the sample, with average inflation 44 April 28, 2009
ates and money growth rates way above 1,000 percent per year. There are reasons to expect that these are exceptional cases 1 , characterised by corruption, internal disruptions and even civil war where economic and social institutions have broken down, and hence not representative for the sample as a whole. Stepwise exclusion of high-inflation countries implies a decline in the explanatory power but average money growth still explains more than 50 percent of inflation differentials, even for the sub-sample with average inflation below 50 percent. For the relatively low-inflationary, developed economies, the correlation between M1 and the price level is weaker although still significant. However, using broader measures of money suggests a strong relationship. For instance, since 1980 differences in average M2 growth “explain” 65 percent of differences in average inflation among 19 developed economies, of which one is the eurozone aggregate (upper right graph). 2 Taking the result literally suggests that one percentage point higher average annual M2 growth is consistent with 0.3 percentage point higher average annual inflation in the OECD-sample. Money and the real economy: the transmission mechanism According to our results, there is a clear and fairly strong link between money and economic activity/inflation, at least in the longer term. Admittedly, the correlation might go both ways, but that does not matter for the policy conclusions: if money grows strongly over extended periods, inflation is likely to be high as well. One important question is how a link from money to economic activity/inflation might be established, i.e. how does a monetary acceleration feed into higher inflation? There are two prime candidates: Money growth affects inflation via output gap and expectations • Money growth affects inflation via real economic activity and resource utilisation • Money growth affects inflation via inflation expectations Inflation and the output gap Sources: Reuters Ecowin and <strong>Handelsbanken</strong> Capital Markets It is an empirical question as to which of these mechanisms is the strongest, but both are likely to work simultaneously. However, this is not a purely academic issue since the relative strength of the two mechanisms might matter a lot to policy makers. In particular, considering the present situation with rapidly increasing unemployment all over the world, central banks will be in deep trouble in the case of money affecting inflation primarily via resource utilisation. For instance, with Swedish unemployment set to increase to 11-12 percent in 2011, it might take until 2015 at least to get unemployment back to NAIRU around 6 percent. As a comparison, when the Swedish GDP gap opened up to similar magnitudes in the early 1990s, it took some eight years from the trough for the economy to return to balance, according to our estimations. Such a scenario would mean a very high risk of a devastating deflationary 1 Examples are economies like Nicaragua and The Democratic Republic of Congo. 2 Naturally, due to the small number of observations, the latter result should be taken with a grain of salt. April 28, 2009 45
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Page 4 and 5: INTRODUCTION Who will pull the worl
Page 6 and 7: Emerging economies have been badly
Page 8 and 9: Consumer spending rebounded in Q1 U
Page 10 and 11: tion is due to the fall in oil pric
Page 12 and 13: The pattern evident in fourth quart
Page 14 and 15: Inflation forecast GDP forecast Sou
Page 16 and 17: Heavy falls in Investment and expor
Page 18 and 19: three quarters, the most rapid incr
Page 20 and 21: Gov’t finances and unemployment S
Page 22 and 23: this outlook, we also sketch an alt
Page 24 and 25: Finnish households have reduced the
Page 26 and 27: to the European Commission, capacit
Page 28 and 29: JAPAN Three more years of slump The
Page 30 and 31: EASTERN EUROPE Troubling times East
Page 32 and 33: CHINA Here’s one on the right tra
Page 34 and 35: Highly restrictive lending quotas w
Page 36 and 37: Slowdown to 5 percent growth in 200
Page 38 and 39: Aggressive cutting to catch-up with
Page 40 and 41: The ECB could adopt a policy of cre
Page 42 and 43: MONEY AND INFLATION Money matters W
Page 46 and 47: spiral taking hold. In the late 199
Page 48 and 49: Global currency and interest rate f

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