ECON102: Principles of Macroeconomics (2021.A.01)

What factors determine the inflation rate? The price level is determined by the intersection of aggregate demand and short-run aggregate supply; anything that shifts either of these two curves changes the price level and thus affects the inflation rate. We have seen how these shifts can generate different inflation-unemployment combinations in the short run. In the long run, the rate of inflation will be determined by two factors: the rate of money growth and the rate of economic growth.

Economists generally agree that the rate of money growth is one determinant of an economy's inflation rate in the long run. The conceptual basis for that conclusion lies in the equation of exchange: MV = PY. That is, the money supply times the velocity of money equals the price level times the value of real GDP.

Given the equation of exchange, which holds by definition, we learned in the chapter on monetary policy that the sum of the percentage rates of change in M and V will be roughly equal to the sum of the percentage rates of change in P and Y. That is,

Suppose that velocity is stable in the long run, so that %ΔV equals zero. Then, the inflation rate (%ΔP) roughly equals the percentage rate of change in the money supply minus the percentage rate of change in real GDP:

In the long run, real GDP moves to its potential level, Y_P. Thus, in the long run we can write Equation 16.2 as follows:

There is a limit to how fast the economy's potential output can grow. Economists generally agree that potential output increases at only about a 2% to 3% annual rate in the United States. Given that the economy stays close to its potential, this puts a rough limit on the speed with which Y can grow. Velocity can vary, but it is not likely to change at a rapid rate over a sustained period. These two facts suggest that very rapid increases in the quantity of money, M, will inevitably produce very rapid increases in the price level, P. If the money supply grows more slowly than potential output, then the right-hand side of Equation 16.3 will be negative. The price level will fall; the economy experiences deflation.

Numerous studies point to the strong relationship between money growth and inflation, especially for high-inflation countries. Figure 16.9 "Money Growth Rates and Inflation over the Long Run" is from a recent study by economist John Thornton. It is based on a sample of 116 countries from 1960 to 2007. Panel (a) includes all 116 countries, while Panel (b) excludes 6 outlier countries with inflation rates ranging from 200% to more than 850%. While the relationship is clearly not precise, the graphs suggest support for the quantity theory of money. A more detailed statistical analysis shows that when the annual inflation rate averages more than 10%, the relationship seems to hold. The Thornton study uses currency as the monetary aggregate because the definitions of M1 and M2 are not stable across such a wide sample of countries over long periods of time.

In the model of aggregate demand and aggregate supply, increases in the money supply shift the aggregate demand curve to the right and thus force the price level upward. Money growth thus produces inflation.

Of course, other factors can shift the aggregate demand curve as well. For example, expansionary fiscal policy or an increase in investment will shift aggregate demand. We have already seen that changes in the expected price level or in production costs shift the short-run aggregate supply curve. But such increases are not likely to continue year after year, as money growth can. Factors other than money growth may influence the inflation rate from one year to the next, but they are not likely to cause sustained inflation.