Money and Inflation

Getting ready for class tomorrow and was reminded of this graph from Mishkin's text:

Larger version

The graph shows two things. First, it shows the long lag between changes in the money supply and changes in the inflation rate. There is a close association between inflation and the growth rate in M1 two years earlier. When the supply shocks of the 1970s are accounted for, the association is even closer.

Second, the association breaks down around 1980, most likely due to the onset of rapid financial innovation around that time (e.g., see the speech by Chairman Bernanke on monetary aggregates and monetary policy). This break down in the relationship is also evident in other measures of the money supply such as M2, particularly after the early 1990s. 

Whether the break down is transitory or permanent is an open question and part of the recent debate between Bernanke and Trichet. Some believe the change in the relationship between money and inflation is because rapid financial innovation has made the money supply difficult to measure. They argue the link between measurements of inflation and money growth will stabilize once again when financial innovation levels off. Others argue the measurement difficulties pose more permanent difficulties.

But whether the break down persists or not, for now it is evident and, along with the corresponding theoretical support for interest rate rules, it helps to explain why the Fed has turned to interest rate targeting and why it pays little attention to (such imperfect) measures of the money supply.

Comments

[William Polley]

Very true, Mark. On a slightly different but not totally unrelated topic, did you notice this in the FOMC minutes today?

"The Chairman noted that the President had recently signed the Financial Services Regulatory Relief Act of 2006, which among its provisions gave the Federal Reserve discretion, beginning October 2011, both to pay interest on reserve balances and to reduce further or eliminate reserve requirements. The Act potentially has important implications for many aspects of the Federal Reserve's operations and the Chairman asked Vincent Reinhart, Director of the Division of Monetary Affairs, to form a committee of Federal Reserve System staff to consider these issues."

This is also due in large measure to financial innovation. The policy landscape has changed significantly in the last few years. In terms of the debate you describe, I think it will require alternative measures of the money supply (like MZM or perhaps something yet to be created) before any stable relationship reasserts itself. But even that seems an open question.

[Mark Thoma]

I hadn't had a chance to read the minutes before reading your summary, so that was the first I had heard of it - thanks.

This would allow the Fed to move toward a channel/corridor system like Canada, Australia, and New Zealand use so maybe that's what they have in mind for the future. Those three countries have eliminated reserve requirements. If anyone is unfamiliar with this, here is a graph and explanation of the corridor/channel system and summary of testimony on the issue.

[laughingsong]

"Financial Innovation." Mmmmm, now there's a euphemism for the deregulation of lending and banking requirements for backing their loans.

[Ken]

Milton Friedman, the free market economist and winner of a 1976 Nobel Prize, has died, a spokeswoman for his family said on Thursday.