It was the summer of 2012 and I was at the pub enjoying myself with friends when I encountered an interesting young gentleman sporting a black t-shirt stamped with the slogan “911 was an Inside Job”. He was an acolyte of former US congressman Ron Paul and an avid listener to Alex Jones’ radio show. When it became clear that I had no time for his bizarre views on the September 11 terrorist attacks, our conversation turned to monetary policy.
On monetary policy, this man’s views were not quite so peculiar, but just as incorrect as his views of September 11. He was highly critical of the US Federal Reserve’s policy of quantitative easing, which he believed would lead to massive inflation. As we now know this did not occur (perhaps one of the reasons for the collapse in the gold price). Whether he knew it or not this man was invoking the quantity theory of money (QTOM) which posits a positive relationship between the growth in money supply and inflation.
The QTOM was popularised by Nobel laureate Milton Friedman during the 1950s and has featured in countless macroeconomics textbooks ever since. A crude version of the economics behind the theory is as follows:
MV ≡ PY
Where M = Money Supply, V = Velocity of money, P = Price level and Y = GDP.
If we assume that V is stable (or only changes gradually over time) and that Y tends towards full capacity/natural level of output then it must be changes in M that cause changes in P. This was the basic logic behind Friedman’s argument. Friedman reworked the above in growth terms to conclude that money supply growth would lead to inflation.
Friedman eloquently made the empirical case for the QTOM by reference to the Japanese inflation of the 1970s. He pointed to a clear correlation between inflation and monetary growth with a 12-18 month lag as he predicted in his theoretical work. However, as the adage goes, correlation does not imply causation and as any student of history will tell you the 1973 Oil Crisis led to widespread inflation across the globe. With this in mind, Friedman’s empirical case for the QTOM appears weaker.
In 1985, when the Reserve Bank of Australia (RBA) formally abandoned money supply targeting, it concluded that money supply does not lead to inflation and moreover that there existed no systematic relationship between money supply and inflation.
Study after study found that the other macroeconomic variables such as wages dominate money supply in terms of explaining inflation. A recent RBA discussion paper on modelling inflation revisited the topic and concluded, “the inclusion of money in our inflation models does not impart significant benefit” precisely because of the lack of hard empirical evidence for a causal relationship.
One view is that the empirical failure of the QTOM is a fulfilment of Goodhart’s law. That is, when the central bank attempts to target money supply to control inflation, investors try to anticipate changes in money supply and invest so as to benefit from it. This destroys any existing relationship between the variables.
Proponents of the QTOM might simply assert that the lag between money growth and inflation is longer than Friedman predicted. For example, former Bank of England Chairman Mervyn King contends that while the 2-5 year correlation between money growth and inflation is not impressive, over periods of 5-10 years, “the correlations become almost perfect”. For this reason, quantity theorists often castigate the Fed for being myopic and using short-term models.
Whilst the jury is not out on this view, it can seem underhanded at times. It is as if people wish to cling to the QTOM and thus postulate a longer lead-time. One of my economics lecturers once joked that if the USA experiences a burst of inflation in 30 years time quantity theorists will blame it on the Federal Reserve’s current monetary policy. The other sneaky tactic quantity theorists employ is talking in terms of correlations (scatter plots, regression analysis, etc) and ensuring that the 1970s features prominently in their datasets.
As the RBA carefully notes, one should not dismiss the role of money in monetary policy. Whilst it is not a strong explanatory variable of inflation it is nevertheless an important “information variable” on the state of the economy. However, I am left wondering why the QTOM is still featured in so many macroeconomics texts since central banks around the world dismissed it decades ago? The problem arises when students only take an introductory economics unit and are left believing that the QTOM is gospel truth. Whilst there is a legitimate need not to overcomplicate things in introductory economics courses, textbooks should go beyond the neat theory and at least acknowledge some of the empirical work on the QTOM.
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