According to Milton Friedman’s famous aphorism, “inflation is always and everywhere a monetary phenomenon.” A look at the data on inflation and the growth of the money supply across countries suggests that the two are indeed very closely related: The correlation between inflation and average M2 growth in 132 countries over the period 1960–2000 is close to one (0.86), suggesting that prices move almost proportionally with the stock of money. And yet the Federal Reserve stopped reporting the broadest monetary aggregate, M3, last year, and the time has long since past that it reported growth rate targets for money aggregates.
Irving Fisher formulated the notion of the almost-proportional relationship between money and prices as the equation of exchange. Loosely speaking, the equation states that the amount of money in the economy multiplied the number of times that money changes hands in a given period (this number is referred to as the velocity of money) must be equal to the value of the transactions conducted in the same period. Fisher’s equation is true by construction; it doesn›t tell you much until you make additional assumptions. If we assume velocity and the volume of transactions are roughly constant over some period of time, for instance, the equation says the relationship between money and prices will be proportional.
Economists used to assume that velocity was, in fact, fairly constant over time, or that it varied with other factors in predictable ways. The evidence we have now suggests this used to be the case but is no longer. If we look at one measure of the money supply, M1* (which is M1 minus the value of currency circulating abroad and is used because a sizable fraction of U.S. currency is held abroad), we see that its velocity of circulation (nominal GDP divided by M1*) has changed over the past century. Until 1960, velocity varied around a constant mean of less than 4, but thereafter it has increased significantly. If velocity is variable and unpredictable, the relationship between money and prices is difficult to characterize, and monetary aggregates can’t help policymakers track inflation.
Nominal interest rates can affect velocity. To see how, think about the flip side of velocity. Flipping over the measure of velocity we looked at above, we get the supply of money over nominal GDP, which is a measure of money demand (that is, money balances held by individuals). Theories of money demand predict that demand declines with the opportunity cost of money, measured by the nominal interest rate of commercial paper, because a higher opportunity cost of holding money induces people to economize on their money balances relative to spending. Over the twentieth century, in fact, the relationship between interest rates and money demand has been negative in the United States. Unfortunately, the relationship does not appear to be stable over time. The demand for money balances was higher in the 60s and 70s than it was in the 80s and 90s, and in the first half of the twentieth century it was higher still. Furthermore, since the beginning of the 80s, money demand has become less sensitive to changes in the interest rate. (Graphically, it has flattened out.) Because interest rates don’t affect money demand (or its inverse, velocity) in a predictable way over time, measures of money can be misleading as sources of information about future prices.
One explanation for why the relationship between money demand and interest rates might have changed is that the assets included in M1 (currency and checkable deposits) no longer capture households’ transactions balances accurately. Deregulation and financial innovation have led to new financial products (such as money market deposit accounts and money market mutual funds) that are not included in M1 but can readily be transformed into means of payments. As such, they are close substitutes to the assets in M1. For instance, the fact that individuals can transfer funds from non-interest bearing checking accounts to savings accounts at a high frequency has reduced the relevance of M1. The lesser importance of M1 is reflected in its declining share in M3. The share of checkable deposits in M3 has declined steadily over time while the share of money funds has been increasing.
Is the velocity of circulation of other monetary aggregates more stable than the velocity of M1? In fact, the velocities of M2 and M3 have gone through substantial swings, too. While the velocity of M2 appeared to be fairly stable until the end of the 80s, it increased sharply from the beginning of the 90s until 1997 and fell abruptly in the subsequent five years. The velocity of M3 declined steadily until the mid 80s, increased from 1987 to 1995, and fell again from 1995 to 2003. These movements cannot be explained by changes in nominal interest rates only. Again, deregulation and financial innovation that make portfolio readjustments among monetary assets easier have played a role.
The instability of velocity notwithstanding, can the changes in the rate of growth of money supply help predict the future changes in the inflation rate? Changes in money growth rates predict fairly well changes in the inflation rate that occur two years later—until the end of the 70s. Since then, ample movements in the money supply do not appear to predict accurately either the magnitude or the direction of future changes in the inflation rate. As a result, monetary aggregates cannot be used alone to predict or control inflation.
But as Chairman Ben Bernanke indicated on November 10, 2006: “although a heavy reliance on monetary aggregates as a guide to policy would seem unwise in the U.S. context, money growth may still contain important information about future economy developments. Attention to money growth is thus sensible as part of the eclectic modeling and forecasting framework used by the U.S. central bank.”