According to the quantity equation, the inflation rate and the rate of money growth are closely linked. As the famous economist Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” [1] By this he meant that inflation could always ultimately be traced to “excessive” money growth. Keep in mind that we are talking about the long run here. Over shorter periods of time, changes in the money supply affect the level of real economic activity and have correspondingly less effect on the inflation rate. Inflation and Money Growth in the United States Figure 11.4 “Inflation and Money Growth in the Short Run” and Figure 11.5 “Inflation and Money Growth in the Long Run” show the relationship between inflation and money growth for the United States. For this discussion, money growth is measured as M1. The rate of money growth is on the horizontal axis, and the annual inflation rate is on the vertical axis. Figure 11.4 Inflation and Money Growth in the Short Run
The two figures differ in the time horizon used to compute the growth rates. In Figure 11.4 “Inflation and Money Growth in the Short Run”, month-to-month changes in money and prices are used to calculate annual growth rates. If you listen to a radio report or read the newspaper about inflation, typically you will first be told about the monthly Consumer Price Index (CPI) and then be given an annual inflation rate. The annual growth rate is the amount by which the variable would increase if the monthly growth rate persisted for a year. The conversion is simply to take the monthly percentage change and convert it into an annual percentage change by multiplying by 12. So if the CPI increased from 112 to 118 over the past month, then the change for the month would be calculated as follows:
118−112 112 = 6112 = 0.0536 = 5.36 percent.
If prices increased at this rate each month at this same rate, then prices would increase by 12 × 5.36 percent = 64.32 percent over the year. The data for Figure 11.4 “Inflation and Money Growth in the Short Run” start in January 1959 and end in December 2010. So the first observation is the annual percentage change between January and February 1959. Figure 11.5 “Inflation and Money Growth in the Long Run” examines annual growth rates based on observing the money supply and the price level at five-year intervals. The first observation is the annual growth rate for the period starting in January 1959 and ending in January 1964. The annual growth rates for a five-year period are computed for each month starting in January 1964. Here, instead of multiplying a monthly growth rate by 12 to get an annual rate, we divide a five-year rate by 5 to get an annual rate. The point of examining growth rates over longer periods of time goes back to the idea that we are investigating the relationship between prices and the money supply over long periods of time. Comparing these two figures, you can see that the relationship between money growth and inflation is much tighter when we examine five-year periods, as in Figure 11.5 “Inflation and Money Growth in the Long Run”, rather than the monthly changes inFigure 11.4 “Inflation and Money Growth in the Short Run”. This is consistent with the view that the relationship between money growth and inflation is a long-term relationship, not a short-term relationship.