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.