25.1 Empirical Evidence of a Money-Inflation Link

Milton Friedman claimed that “inflation is always and everywhere a monetary phenomenon.”A Monetary History of the United States, 1867–1960. We know this isn’t entirely true because, as we saw in Chapter 23 "Aggregate Supply and Demand, the Growth Diamond, and Financial Shocks", negative aggregate supply shocks and increases in aggregate demand due to fiscal stimulus can also cause the price level to increase. Large, sustained increases in the price level, however, are indeed caused by increases in the money supply and only by increases in the money supply. The evidence for this is overwhelming: all periods of hyperinflation from the American and French Revolutions to the German hyperinflation following World War I, to more recent episodes in Latin America and Zimbabwe, have been accompanied by high rates of money supply (MS) growth. Moreover, the MS increases in some circumstances were exogenous, so those episodes were natural experiments that give us confidence that the reduced-form model correctly considers money supply as the causal agent and that reverse causation or omitted variables are unlikely.

Economists also have a structural model showing a causal link between money supply growth and inflation at their disposal, the AS-AD model. Recall that an increase in MS causes the AD curve to shift right. That, in turn, causes the short-term AS curve to shift left, leading to a return to Y_nrl but higher prices. If the MS grows and grows, prices will go up and up, as in Figure 25.1 "Inflation as a response to a continually increasing money supply".

Figure 25.1 Inflation as a response to a continually increasing money supply

Nothing else, it turns out, can keep prices rising, rising, ever rising like that because other variables are bounded. An increase in government expenditure G will also cause AD to shift right and AS to shift left, leaving the economy with the same output but higher prices in the long run (whatever that is). But if G stops growing, as it must, then P* stops rising and inflation (the change in P*) goes to zero. Ditto with tax cuts, which can’t fall below zero (or even get close to it). So fiscal policy alone can’t create a sustained rise in prices. (Or a sustained decrease either.)

Negative supply shocks are also one-off events, not the stuff of sustained increases in prices. An oil embargo or a wage push will cause the price level to increase (and output to fall, ouch!) and negative shocks may even follow each other in rapid succession. But once the AS curve is done shifting, that’s it—P* stays put. Moreover, if Y* falls below Y_nrl, in the long run (again, whatever that is), increased unemployment and other slack in the economy will cause AS to shift back to the right, restoring both output and the former price level!

So, again, Friedman was right: inflation, in the sense of continual increases in prices, is always a monetary phenomenon and only a monetary phenomenon.This is not to say, however, that negative demand shocks might not contribute to a general monetary inflation.

Stop and Think Box

Figure 25.2 "U.S. M1 and P growth" compares inflation with M1 growth laggedThe time it takes for a policy to change on a variable, a cause to create an observable effect. two years. What does the data tell you? Now look at Figure 25.3 "Government debt-to-GDP ratio" and Figure 25.4 "U.S. unemployment rates, 1961–1972". What caused M1 to grow during the 1960s?

Figure 25.2 U.S. M1 and P growth

Figure 25.3 Government debt-to-GDP ratio

Figure 25.4 U.S. unemployment rates, 1961–1972

The data clearly show that M1 was growing over the period and likely causing inflation with a two-year lag. M1 grew partly because federal deficits increased faster than the economy, increasing the debt-to-GDP ratio, leading to debt monetization on the part of the Fed. Also, unemployment rates fell considerably below the natural rate of unemployment, suggesting that demand-pull inflation was taking place as well.