How Accurate Are Forecasts of Inflation Based on the Quantity Theory?

Note that the accuracy of the quantity theory depends on whether the key assumption that velocity is constant is correct. If velocity is not constant, then there may not be a tight link between increases in the money supply and increases in the price level.

For example, an increase in the quantity of money might be offset by a decline in velocity, leaving the price level unaffected. Because velocity can move erratically in the short run, we would not expect the quantity equation to provide good forecasts of inflation in the short run.

Over the long run, however, there is a strong link between changes in the money supply and inflation. Panel (a) of Figure 2.3 shows the relationship between the growth of the M2 measure of the money supply and the inflation rate by decade in the United States. (We use M2 here because data on M2 are available for a longer period of time than for M1.)

Because of variations in the rate of growth of real GDP and in velocity, there is not an exact relationship between the growth rate of M2 and the inflation rate. But there is a clear pattern that decades with higher growth rates in the money supply were also decades with higher inflation rates.

In other words, most of the variation in inflation rates across decades can be explained by variation in the rates of growth of the money supply. Panel (b) provides further evidence consistent with the quantity theory by looking at rates of growth of the money supply and rates of inflation across countries for the decade from 1999 to 2008.

Although there is not an exact relationship between rates of growth of the money supply and rates of inflation across countries, panel (b) shows that countries where the money supply grew rapidly tended to have high inflation rates, while countries where the money supply grew more slowly tended to have much lower inflation rates.

Over this decade the money supply in Zimbabwe grew by more than 7,500% per year. The result was an accelerating rate of inflation that eventually reached 15 billion percent during 2008. Zimbabwe was suffering from hyperinflation—that is, a rate of inflation that exceeds 100% per year. In the next section, we discuss the problems that hyperinflation can cause to a nation’s economy.