Money Growth, Output Growth, and Inflation: A Reexamination of the Modern Quantity Theory's Linchpin Prediction

Abstract

1. IntroductionOver the years, the quantity theory of has been extended and refined. All versions, however, begin with the well-known equation of exchange, MV = PQ, where Q is the level of national output (real gross domestic product, GDP), P is the general price level, V is the velocity of circulation, and M is the quantity of money. To convert this equation--actually an identity--into a theory, one of the four variables contained therein must be specified as functionally dependent on the other three. Monetarists argue that P is the dependent variable (Sprinkel 1971). Specifically, they argue that M is determined by the national monetary authority; that V is determined by a variety of both secular and cyclical factors;1 that changes in V do not consistently offset changes in M; and that Q is determined by capital, labor, and technological advances (Sprinkel 1971).The monetarist theory of inflation is a long-run theory; it does not purport to explain short-run increases in the general price level (Hafer and Wheelock 2001). Monetarists argue that short-run inflation stabilization is not feasible and, therefore, that monetary policy should be confined to inflation concerns over a relatively long horizon.2John Moroney (2002, p. 399) asserts that in the traditional version of the quantity theory, ... a country's long-run inflation rate increases [one-to-one] with its rate. The modern wrinkle is that inflation is mitigated by real GDP growth (emphasis added). This assertion is consistent with the famous dictum of Milton Friedman (1968, p. 18) that ... inflation is always and everywhere a monetary phenomenon, produced in the first instance by an unduly rapid in the quantity of money (emphasis added). Friedman's assertion is not that an increased rate is the sole cause of inflation in the long run--just the most important cause (Friedman and Friedman 1980). An increase in inflation can also be caused by a decrease in the rate of Q (or, theoretically, even an increase in the rate of V), as is easily seen by solving the equation of exchange for P and then taking logs and first differences.After taking logs and first differences,3 Moroney (2002) obtains an estimating equation in which inflation is functionally dependent on the rates of the stock and real GDP:(Formula Omitted. See article image.) where Y is Δ ln P, X is Δ ln M, Z is Δ ln Q, and u is a random disturbance term that includes velocity changes. (Δ is the first difference operator.) The modern quantity theory's model-implied restrictions--which are testable predictions--are that the intercept is zero, the coefficient of the stock rate is plus one, and the coefficient of the rate of real GDP is minus one. Arguably, this joint hypothesis is the linchpin prediction of the modern quantity theory: If the hypothesis is rejected by the data, the theory falls.Using long-run (1980-1993) cross-section data on 81 countries, which he takes from the World Bank's World Development Report 1995, Moroney (2002) tests the joint hypothesis (β0 = 0, β1 = 1, β2 = -1) and incorrectly claims that the hypothesis cannot be rejected at even the 0.01 level of significance.4 As will be shown in the next section, the joint hypothesis is rejected decisively. Fortunately, however, it will also be shown that a modification to Moroney's model specification helps to salvage the most substantive part of the modern quantity theory's implied restrictions.2. Modification to the Quantity Theory SetupIn contrast to the conventional quantity theory setup, in which the economy's real activity is determined entirely outside its monetary sector (Fama 1982; Moroney 2002)--that is, in which no provision is made for the possibility that the monetary authority's actions could have an adverse effect on output5--the present article entertains the possibility that Y and Z are jointly determined. …