Question 9

Fried111an and Schwartz (1 963) stated that ' Inflation is always and everywhere a
monetary phenon1en on'.

(a) E xplain what is 1neant by the above phrase. U se the Quantity Theory of Money
to support your answer.
(5 marks)
(b) Discuss two hypotheses that can be tested to check whether inflation is 'always
and everywhe re a m onetary phenomenon'.
(5 marks)
( c) Discuss the e1npirical evide nce r elating to t he statem ent that ' I nflation is always
and everywhere a 1nonetary phenome non' .
(10 marks)
(a) Variations in money lead to variations in inflation. R.ewriting the Quantity Theory of
lvloney in log-differences gives:
p = m - y + v.
If changes in output y and velocity v are taken as exogenous, then any changes in m will
lead to proportional changes in p.

(b) Following de Grauwe and Polan (2005) one can rewrite the above relation as an econometric
model:
Pt = a + f31mt + f32Yt + Ut
where changes in the volatility (vt) are subsumed in the error tern1 Ut as they are assumed
unobservable. Using this framework, the following two hypotheses can be tested: the
'proportionality proposition' t hat movements in inflation are proportional to movements in
the growth of money, i.e. (31 = 1, and the 'orthogonality proposition' (or 'neutrality
proposit ion') that states that output and volatility are exogenous, i.e. f32 = 0.
(c) This discussion can draw on many different papers such as de Grauwe and Polan (2005),
which is part of t he required reading list. Candidates are expected to discuss empirical
evidence on both of the propositions highlighted in part (b) . De Grauwe and Polan (2005)
find partial support for the above statement. Their findings can be summarised as follows.

l. They find little evidence for the 'proport ionality proposition'. There is a strong relation
between the long-run growth rate of money and inflation; this relation is not
proport ional. This strong link is wholly d ue to high-inflation countries.
2. In low-inflation countries, the 'neut rality proposition' holds; in the long run, inflation
and money growth are independent of each other.

3. It seems that volatility increases with higher inflation.

4. The time it takes for the long-run effects of n1onetary expansions to be realised depends
on the level of inflation. For high-inflation countries the transmission may happen within
a year .
5. In low-inflation countries 1noney growth and inflation are inversely related; while in
high-inflation cow1tries they are positively related.

The above imply that using t he money stock as a guide for steering price stability might not
be useful for low-inflation count ries.
Question 9

In their a rticle ' Mone y, inco1ne , prices and inter est rates' Friedn1ai1 and Kut tner
(1992) discuss the infor1na tion conte nt of vai·iations in a r ange of US monetary
a ggregates a nd short -t erm inter est rates r egarding the macroeconomy.

(a ) Expla in what is 1neant in this contex t by the 'inforn1ation content' of monetary

aggrega tes a nd s hort-t erm inter est rates .
{5 1narks)
(b ) Discuss the empirical evide nce r ega rding the inforn1ation conte nt of monet ar y
aggrega tes and s hort-t erm inter est r a t es .
(10 1narks)
( c) Most cen t ral ba nks fo cus the ir n1one tai·y policy announcem e nts on short-term
inter est rates rather than monetai·y aggregates. Is t his approach supported or
dispute d by your answer s in (a) and (b)? Explain your answer.
(5 n1ai·ks)
(a) In the context of Friedman and I(uttner (1992), the information content of policy
instruments can be defined as the extent to ·which they a.re regularly and reliably associated
with variations in relevant macroecono1nic variables such as income, prices, employment, or
other variables that the central bank is trying to influence.
(b) A good answer discusses both sides of the argument regarding the infonna.tion content of
111oney. Natural choices would be the results found in Friedman and l(uttner (1992) and the
results of Aksoy and Piskorski (2006), both of which are required reading in the subject
guide.
Friedman and Kuttner (1992) show that the information content of money has been
drastically reduced since the 1980s and can no longer explain variations in US GDP and
inflation. Short-term interest rates retain their inforn1ation content th roughout the entire
sample.
On the other hand, Aksoy and Piskorski (2006) argue that there is in fact a relation between
money growth and macroeconomic fundamentals (in the US) , but this is obscured by the
way money aggregates are 1neasured. Once money aggregates are redefined/ measured as
domestic money aggregates, money aggregates do contain val uable information about
111acroeconomic fundamentals.
(c) This approach is supported based on information content aJ·guments for most advanced
econo1nies. As interest rates currently have a better and stable informational content to
explain variations in real output and to some extent inflation than monetary aggregates,
these a.re the natural focus for monetary policy announcements. In any case, setting policy
rates is done through 1noney markets (open market operations), therefore policy
implementation will directly affect liquidity conditions, thus monetary aggregates.