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Money Supply And Inflation Take Home Project Notes

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Candidate Number 2646A

Economic Tripos Part I Paper 3 Statistics take-home Project Question 1: "Using data available to you, examine the claim that the excess money supply causes inflation."

Introduction "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output."
- Milton Friedman, The New Palgrave Dictionary of Economics (1987) Advocates of monetarism such as Milton Friedman emphasized the role of money supply in the economy in determining nominal output. According to monetarism, excess money supply growth in the long run will result in an increasing price level and will not affect real variables. Friedman is also known for reviving the interest in the Quantity theory of money, which uses the following equation1: MxV




M: Money supply

P: Price level

V: Income velocity

Y: Real output

This equation is based on the assumption that the number of transactions is roughly proportional to real output and furthermore assumes that velocity is constant. With constant velocity, we can relate changes in the money supply to changes in nominal output. The quantity equation, written in percentage-change form, is
%[?]M + %[?]V =

%[?]P + %[?]Y


Constant velocity means that %[?]V = 0. The growth in output is determined by exogenous factors. If money supply grows at the same rate as the growth in real output, we would have %[?]P = 0, so there would be no inflation. Money supply growth that exceeds the growth in real output is called excess money supply growth (EMSG). As we can see from equation (3), any EMSG will lead to increases in the

1 Mankiw (2006): Macroeconomics, p102-106.

1 Candidate Number 2646A

price level. Thus, the quantity equation tells us that in the long run, the central bank has control over inflation by controlling the money supply. The general money demand function is:2

( M / P) d = L(i, Y )


M/P: Real money balances i: Nominal interest rate Y: Real output Money demand is positively related to real output, but negatively related to the interest rate. For the definition of ESMG, we could add a positive function of the nominal interest rate. This is because a higher interest rate would decrease money demand but leave money supply unchanged. Higher interest rates thus increase the amount of "excess money supply". However, since it is difficult to find a good estimate of the coefficients of the money demand function, I will not include the nominal interest rate in the use of EMSG.

Methodology I will examine whether the relationship between EMSG and inflation as postulated by the Quantity theory of money holds. According to the Quantity theory, one would expect a positive, one to one relationship. First, I will use data3 for the United Kingdom from 1965 - 2008 and run a regression using ordinary least squares (OLS). I will assume the following linear relationship:

p t = a + b [?]M t - k + e i


p t : Inflation rate in year t

a : Constant rate of inflation
[?]M t - k : Rate of EMSG in year t-k

k :Lag in years
b :Parameter showing relationship between inflation and EMSG

e t : Error in year t not explained by the model 2

Mankiw (2006): Macroeconomics, p114. Data for money supply growth and changes in CPI were taken from the International Financial Statistics of the IMF. The measure of money is the IMF definition of "broad money", thus M4 for the UK. Data for real GDP were taken from ONS. See the Appendix for details. 3


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