Money Growth, Output Growth, and Inflation: Estimation of a Modern Quantity Theory

Abstract

1. Introduction During the years 1980-1993, annual inflation averaged 81.5% in Latin America, 12.3% in Africa, but only 6.4% among 16 countries in the OECD. Within Latin America, inflation ranged from 8.2% in Honduras to 374.3% in Argentina and in Africa from -0.6% in the Republic of the Congo to 61.6% in Sierra Leone. What are the reasons for these large differences? If cross-country differences in inflation can be linked closely to corresponding differences in money growth, the reason is clear. But if the link is weak, then other reasons must be sought. Several authors have recently rejected money growth as an explanation of inflation. There are three lines of criticism. The first, typified by Baba, Hendry, and Starr (1992); Estrella and Mishkin (1997); and Cochrane (1998), argues that the income velocity of (and thus the demand for) monetary aggregates is so unstable that money growth is an unreliable explanation. A second criticism, closely related to the first, is a time-series issue: If money, the price level, and output are not cointegrated, then there is no stable long-run relationship among them. Some researchers find evidence of cointegration (Hoffman and Rasche 1991; Baba, Hendry, and Starr 1992; Stock and Watson 1993; Hoffman, Rasche, and Tieslau 1995; Swanson 1998; Carlson et al. 2000; Dutkowsky and Atesoglu 2001), but others do not (Stock and Watson 1989; Hafer and Jansen 1991; Friedman and Kuttner 1993; Thoma 1994). The cointegration question remains unsettled. A third criticism is quite distinct from the first two. It argues that in dynamic general equilibrium models with infinitely lived households, money in the household utility function, and rational expectations, there is a class of policy rules with a unique solution that shows that the price level is independent of monetary policy but dependent strictly on policy. This fiscal theory of price level determination breaks any link between money growth and inflation. The key models were developed by Leeper (1991), Sims (1994, 1996), and Woodford (1994, 1995, 1998). A simple version is summarized succinctly by McCallum (2001), who demonstrates an alternative mathematical solution to a fiscalist that yields a monetary explanation of the price level. But the monetarist foundations are under vigorous attack.1 This paper specifies and estimates a modern version of the quantity theory of money growth, real GDP growth, and inflation. Its traditional feature is that a country's long-run inflation rate increases with its money growth rate. The modern wrinkle is that inflation is mitigated by real GDP growth. I assume that real GDP growth is governed by exogenous forces such as growth in human capital, physical capital formation, and technological progress. The model makes no attempt to explain GDP growth rates; long-run neutrality is presupposed. I show that the quantity theory can be written as a regression model whose theoretical implications can easily be tested (section 3). This paper then makes three empirical contributions. The first is to estimate a long-run version of the quantity theory and test its implications statistically (sections 5 and 6). The estimates are long run in the important sense that inflation, money growth, and real GDP growth rates are annual averages computed for 81 countries over the 14 years from 1980 to 1993. Short-run changes in the series are excluded by design. The second is to partition statistically the roles of money and real GDP growth as determinants of inflation (section 7). The third is to conduct out-of-sample forecasts (section 8). Here we discover how well the model, estimated for one group of countries, predicts inflation in others. This paper differs from previous work in three important ways. First, earlier research has not been based on theoretically grounded regression models (Friedman 1956, 1968; Klein 1956; Friedman and Friedman 1980; Friedman and Schwartz 1982; McCandless and Weber 1995; Rolnick and Weber 1997). …