“If the money supply in an economy is too high, prices tend to rise (inflation).”

Based on estimated DSGE models, I show that velocity shocks cause, ceteris paribus, comparatively much larger decreases in the gain between money growth and inflation. [Note: Full paper provides empirical evidence on the long-run relationship between money growth and inflation, supporting a positive link in standard conditions.]

The quantity theory of money (QTM) is a central tenet of monetary economics. According to QTM, money growth is an essential driver of inflation. Many textbooks suggest that the long-run relationship between money growth and inflation is reliable across time and countries. Milton Friedman famously discovered that inflation is “always and everywhere a monetary phenomenon” and that monetary policy…

If the money supply grows too big relative to the size of an economy, the unit value of the currency diminishes; in other words, its purchasing power falls and prices rise, leading to inflation.

The strength of the link between money growth and inflation depends on the inflation regime: it is one-to-one when inflation is high and virtually non-existent when it is low. An upsurge in money growth preceded the inflation flare-up, and countries with stronger money growth saw larger inflation forecast errors.

Monetarism maintains that the money supply (the total amount of money in an economy) is the chief determinant of current-dollar GDP in the short run and of the price level in the long run. Friedman proposed a fixed monetary rule, which states that the Fed should be required to target the growth rate of money to equal the growth rate of real GDP, leaving the price level unchanged. If the economy is expected to grow at 2 percent in a given year, the Fed should allow the money supply to increase by 2 percent.

The effect of money growth on inflation weakened notably after the 1980s before strengthening after 2020. There is evidence that this time variation is related to the pace of price changes, as we find that the maximum impact of money growth on inflation is increasing in the trend level of inflation.

Chart 1 shows that money growth and inflation have broadly moved in line since the 1970s in the euro area. Periods of higher money growth have generally been associated with higher inflation, while subdued money growth has typically coincided with low inflation.

Inflation is in essence a monetary phenomenon. The rate of growth and the acceleration of the money supply explain the rate of inflation and its acceleration, respectively. Friedman's model does not exclude that a change in the rate of growth of the money supply can have a short-run effect on the real variables of the system.

Monetarists hold that inflation is a purely monetary phenomenon that can only be produced by expanding the money supply at a faster rate than the growth of capacity output. Thus at any given time the actual rate of inflation is seen as reflecting current and past rates of monetary expansion.

When analysing the full sample of countries, we find a strong positive relation between long-run inflation and the money growth rate. There is a strong link between inflation and money growth both in the high- (or hyper-) inflation and low-inflation countries in the sample (on average less than 10% per annum). The data taken in analysis seem to indicate that once we have an increase in the Money Supply we are going to have an increase in the price level that we call inflation.

This paper questions the usefulness of simple money growth-inflation regressions for understanding the inflation process. It finds that the money-inflation link is highly unstable across time and countries, especially in low-inflation environments.

Starting in the 1960s, economist Milton Friedman's monetarism defined the macroeconomic debate. His greatest victory occurred at the end of the 1970s when the Federal Reserve led by Paul Volcker accepted responsibility for inflation rather than blaming it on cost-push inflation. The Volcker–Greenspan monetary policy concentrated on restoring price stability and succeeded without the recurrent spells of high unemployment predicted by Keynesian economists, who considered inflation a nonmonetary phenomenon.

Under this rule, constant increases in the growth of the money supply would be generated through open market operations conducted by the Fed. The monetarist framework emphasizes that excessive money supply growth relative to real economic growth produces inflation, while controlled money supply growth aligned with productive capacity maintains price stability.

When money in circulation grows faster than goods produced in the economy, high levels of inflation can occur. An increase in the money supply coupled with a strained economy, such as a supply chain crisis, can lead to increases in inflation.

Therefore there is a direct link between the money supply growth rate and the inflation rate. It follows that any changes in the growth rate of the money supply will show up one-for-one as changes in the inflation rate. If the monetary authorities want a low level of inflation in the long run, then they should aim to have the money supply grow just a little bit faster than the growth rate of output.

The nobel prize winning economist Milton Friedman once said that 'Inflation is always and everywhere a monetary phenomenon.' The evidence to back his claim demonstrates that when the money supply grows faster than the productive capacity of the economy, prices rise.

Increasing money supply, according to the theory, inevitably leads to higher prices and inflation, while decreasing the money supply leads to deflation and risks, causing a recession. Changes in the money supply also affect employment and production levels, but the monetarist theory asserts that those effects are only temporary, while the effect on inflation is more long-lasting and significant.

With regard to inflation, the Post Keynesian theory of endogenous money explains how cost-push inflations can be self-sustaining because bank lending and the money supply expand to accommodate rising factor prices (particularly nominal wages), so that there is no monetary constraint forcing such inflations to burn themselves out. This contrasts with the monetarist approach to inflation, in which the exogeneity of the money supply means that cost push inflations cannot persist indefinitely without accommodation by the monetary authority.

Research results show that money supply and inflation are closely related, and the money supply directly affects economic growth. It is found out that the continuous increase in the money supply causes inflation in the long-term.

The validity of the monetary theory of inflation requires that the general price level and the money supply grow at the same rate or at close rates. If velocity changes, inflation could arise even without an increase in the money supply. Also, an increase in the money supply in excess of output growth may not cause inflation if it is offset by a drop in the velocity of circulation.

As a consequence, the price level, or inflation rate, can be explained primarily by reference to the supply side, that is, by the behavior of the money supply. [Implication] is that control of the money stock is the key to controlling inflation.

While monetarist theory predicts that excess money supply causes inflation, empirical evidence in the early 1980s showed that high rates of money growth (particularly M1) did not consistently predict inflation increases, leading to a decline in the predictive power of monetary aggregates and prompting central banks to shift toward interest-rate targeting rather than money-supply targeting.

Monetarists say that inflation is caused by a growth in the money supply—or money stock—by which they mean the amount of money 'out there.' For his 2016 article, 'Rapid Money Supply Growth Does Not Cause Inflation,' Richard Vague compiled some data that suggest otherwise.

Contrary to popular thinking, inflation is not about increases in the prices of goods and services but about increases in money supply. [Note: This redefines inflation as money supply growth itself, challenging the claim's equation of high money supply with rising prices.]

For excess liquidity to create inflation, it needs to lead to a sustained increase in spending and loan growth. So far, bank lending has been anemic while the global velocity of money and the money multiplier has fallen more than during the Great Financial Crisis.