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.

INFLATION – DEFINITION AND BASIC INFORMATION

What Is Inflation? The Effects Of Inflation On Real Estate?

Each year and every year the Federal Reserve system increases the money supply. As more money chases after a slowly increasing supply of properties, property prices go up—even without an overall favorable change in the underlying forces of supply and demand (market appreciation). The Federal Reserve specifically designs its monetary policies to create a modest (1.5 to 3.0 percent) annual gain in the Consumer Price Index (CPI).

Sometimes, though, the Fed loses control of inflationary price increases (late 1940s, the entire 1970s, early to mid 1980s). During those superheated, inflationary times, real estate prices will often experience inflationary gains of 6 to 12 percent a year. Buy now and then cheer for inflation.

Interest Rates and Inflation

Journalists repeatedly perpetuate the myth that our so-called “current historically low mortgage interest rates” have caused the recent price run-ups in housing. In reality, today’s 30-year mortgage interest rates of 5 to 7 percent only seem low relative to those mortgage rates of 8 to 16 percent that we experienced throughout much of the 1970s and 1980s.

During most of our country’s 225-plus years of history, mortgage interest rates typically have ranged between 3 and 6 percent. So, today’s rates actually stand toward the high-average end of history—not the historically low. But, still, you might ask, what happens to real estate prices if interest rates do go up?

Higher Interest Rates Are Caused by Higher Inflation

Long-term interest rates climbed dramatically during the 1970s and 1980s because the Consumer Price Index (inflation) jumped from the somewhat mild annual levels of 2.5 to 4.0 percent of the early to mid1960s all the way up to 13 percent in 1982. And for the record, you might note that during those 16 years of increasing inflation and skyrocketing interest rates (from 1970’s 6.0 percent to 1981’s 16 percent), most property values nearly tripled.

Although higher inflation drives up interest rates, inflation also drives up rent levels and construction costs. Even better for investors who own real estate, when inflation heats up, the smart money flees financial assets (stocks and bonds) in favor of hard assets (real estate, gold, collectibles). As a result, property prices are pushed even higher as stock and bond prices stagnate or decline.

For example, in 1964, the stock market’s Dow Jones Industrial Average peaked at close to 1,000. In 1981, it sat at less than 800—20 percent below its high mark of 17 years earlier. During this same 17 year period of higher interest rates and inflation, the nationwide median house price zoomed from $25,000 to nearly $75,000.

History proves that over lengthy periods, higher interest rates do not hurt property values. Quite the contrary, higher interest rates (which merely reflect high inflation) propel property prices to new record heights.