According to monetarism, inflation can be predicted precisely by the change in money supply and GDP growth.
Does "money supply" here refer to M1 or M2, i.e. does it include debts created by private banks?
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1$\begingroup$ Empirically, inflation cannot be predicted precisely by the change in money supply and GDP growth or by anything else $\endgroup$– HenryCommented Aug 10, 2020 at 13:47
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1$\begingroup$ In particular the "velocity of money" is neither stable nor predictable. See fred.stlouisfed.org/series/M2V $\endgroup$– HenryCommented Aug 10, 2020 at 13:50
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2 Answers
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The money supply is in theory interpreted broadly so from that perspective $M2$ or even $M3$ would be more appropriate. Also empirical studies in this strand usually use $M2$ see for example Sargent and Surico (2011).
However, you should note that nor the quantity theory of money nor monetarism claims inflation can be predicted solely by change in money supply and GDP growth.
Simple quantity theory of model is given by:
$$P=MV/Y$$
Where $P$ is price level, $M$ money supply, $V$ velocity of money and $Y$ real output. In more complex models expectations of these quantities matter as well. Hence it does not make sense to equate inflation to changes in $M$.
Furthermore, even though the above relationship is useful for structural modeling and creating analytical models it is practically useless for near term forecasting. If that’s your ultimate aim you would have more luck with augmented New Keynesian Philips curve.
answered Aug 10, 2020 at 12:15
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Only if all real resources are fully employed, is it quite clear that addition of new money will cause inflation rather than real gdp growth.
But, its critical to remember that its the Flow of money rather than the Stock which will cause inflation and that flow depends on both the stock of money (money supply) And the Velocity of circulation of money.
BTW the term inflation is worth considering defining better as some assume it to mean CPI inflation (which i assume you mean here), others assume it to include Asset pri e inflation, and others assume it means simply the rate of change of money supply!
On this topic, i encourage reading of Professor Richard Werners Disaggregated Quantity Theory of Credit.
