Monetary aggregates and inflation: A new view on an old relationship

Gianni Amisano () and Roberta Colavecchio

No 195, BCL working papers from Central Bank of Luxembourg

Abstract: Despite the key role that money plays in the economy, its perceived relevance for monetary policy has changed considerably in the last few decades. According to the quantity theory of money, the long run is characterized by a one-to-one link between money growth and inflation, an assertion that was strongly validated by cross-country empirical evidence from the post-war period. However, this link has displayed signs of instability over time, complicating the use of monetary aggregates to guide policy and as predictors for inflation. This paper reviews the link between money growth and inflation in the theoretical and the empirical literature to assess whether money growth could have provided an early warning of risks to medium-term price stability for the US and the euro area. Our approach takes a regime-dependent view of the money growth-inflation link and evaluates the information content of monetary variables as warning signals for shifts across inflation regimes. Our results show that money growth can be useful to predict inflation in some episodes, such as the 1970s, the early 1980s and the recent post-pandemic phase. Our results also explain why money growth apparently ceased to provide a useful signal to predict inflation from the 1990s until 2021. We conclude that the money growth-inflation relationship is non-linear, with faster money growth signalling a higher probability of entering a “High” inflation regime, thus providing a sharper assessment of the risks to price stability. Classification-JEL: C11, E31, E51

Keywords: Quantity theory of money; money growth; inflation; regime-switching model; Bayesian inference (search for similar items in EconPapers)
Pages: 25 pages
Date: 2025-02
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Persistent link: https://EconPapers.repec.org/RePEc:bcl:bclwop:bclwp195

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