Money/Asset Ratio as a Predictor of Inflation

Abstract

This paper modifies a P-star model to forecast inflation using an argument that is in line with the concept of “price gap”. Liquid assets such as government bonds are also included to measure money demand for asset transaction. The out-of-sample forecast results show that, at least since the early 1990s, money supply/government debt ratio has been a useful predictor of U.S. inflation over one- to three-year horizons. The paper also argues that inflation dynamics in the U.S. since the early 1960s can be explained by two ratios: money supply and government debt as percentage of gross domestic product. Moreover, the relationship between inflation and government debt is negative as the latter positively affects the demand for money. Therefore, a low inflation today can be explained by a high government debt relative to money supply.