Money Supply M2 & Inflation

Inflation (PCE) followed M2 Money Supply up and is following it down. About an 18m lag. When MS growth exceeds real output, you have inflation. Too much money chasing too few goods.

However in 2008, money base was increased but did not increase M2 due to swapping bonds for reserves. (Increased their reserve ratio) Therefore, it did NOT reach the economy.

Enter Quantity Theory of Money

MV = PY

M = Money Supply

V = Velocity of Money

P = Price Level

Y = Real GDP

Growth rate form of the equation of exchange (m + v = p + y, where the lowercase letters represent growth rates given as percentage changes).

Assuming that v and y are constant, the growth rate form of the equation of exchange implies a linear relationship between the variables m and p. The 45-degree line that has been drawn through the grand means of the 110 observed countries intercepts the x-axis at near-0.

This implies that velocity and real output growth are very close to being constant, and that the money supply growth rate and inflation have a near one-to-one relationship.

There is a tight relationship between the growth rate in the money supply and inflation.

Therefore, a higher (lower) rate of growth in the money supply will result in a proportionately higher (lower) rate of inflation.

“Inflation is always and everywhere a monetary phenomenon” Milton Friedman

Sources:

– FRED

– On the Quantity Theory of Money: Some Monetary Facts By Steve Hanke, Zixiang Ma, & Ruiyuan Cheng