Morningstar - Q4 2022 - 48

Strategies
Is Inflation Always and Everywhere
a Monetary Phenomenon?
Perhaps, but it can be hard to tell.
QUANT U
Paul D. Kaplan
With the return of inflation, politicians,
economists, and various commentators are
discussing the reasons for it and methods for
combating it. Naturally, the ideas of the
late Milton Friedman, Nobel laureate and founder
of the monetarist school of macroeconomics,
are part of this discussion. One of the most
famous things Friedman said was, " Inflation is
always and everywhere a monetary phenomenon "
(Friedman 1970). This assertion is often
interpreted to mean that growth in the money
supply is the sole source of inflation, but
Friedman's ideas are more nuanced than that.
In this issue of Quant U, I explain Friedman's ideas
and combine them with the theory of rational
expectations (Lucas and Sargent 1981) to form a
theory of inflation in which expectations of future
changes in the money supply and other key variables
determine the rate of inflation. I then discuss
the relevancy of Friedman's ideas in understanding
today's inflation and how to combat it.
The Quantitative Theory of Money
Economists related the money supply to the
general price level in the quantity theory
of money first formulated by Nicolaus Copernicus
in 1517. The quantity theory of money
was stated as the equation of exchange:
MV = PY
= L(it
where:
Mt
Pt
Y = real total annual income (measured by,
say, real gross domestic product)
Velocity is supposed to measure the average
number of times each unit of currency
changes hands each year. If velocity and real
income remain constant, changes in the
money supply lead to changes in the price level.
Hence, inflation is a monetary phenomenon.
The problem with the equation of exchange is
that it is little more than an identity-defining
velocity. Friedman (1956) restated the quantity
theory of money as a theory in which both
the supply of and the demand for money jointly
determine the price level.
Liquidity Preference Theory
At the heart of Friedman's theory is function
for the demand of real balances. The level
of real balances is the real value of the money
supply, M/P.
, Yt
)
M = the money supply
V = the velocity of money
P = the general price level (measured by,
say, the Consumer Price Index)
+ cyt
L(i, Y) = e Y
a-bi
c
mt - pt = a - bit
EXHIBIT 1
The Liquidity Preference Function
πt +1 = pt +1
10%
mt - pt = a - b ( rt + Et
2
4
6
8
∞
Source: Morningstar.
$55
48
60
Real Balances
65∑wv
v= t
t = 1
∞
mt = Et
Morningstar Q4 2022
∞
r E ∑wt
=
r
∑
v= t
it
= +rt
Et
πt +1
wv
t mv
70
pt
t
mt
=
1 + b
1
wv
=
1 + b
1 + b
-
1 + b
b
a
+
v- t
pt +1 - pt ) + cyt
brt
-
1 + b
1 + b
cyt
+
Y = $10 Trillion
Y = $12 Trillion
b
1 + b
Et
pt +1
- pt
it
= +rt
Et
πt +1
Economists have formulated various theories as
to why people hold money. These are called
liquidity preference theories. A liquidity preference
function gives the demand for real balances
as a function of several variables that usually
include the nominal rate on bonds (i) and
total real income, but it also can include other
variables-as is the case with Friedman's
formulation. Here, I focus just on the interest rate
and real total income. The liquidity preference
function should be decreasing in the rate of
interest because the higher the rate of interest,
the less attractive money is as an asset
relative to bonds. It should be increasing in total
real income because the higher the level of income,
the more money is needed for transactions.
o
D
Assuming that the liquidity function is stable,
at any point in time (t), the supply of real balances
M must equal the demand for real balances so that:
Mt
Pt
V = PY
= L(it
, Yt
)
Hence, for any given values for i and Y, the
price level is proportional to the money
supply, so the price level, and thus inflation, is a
monetary phenomenon.
L(i, Y) = e Y
a-bi
c
mt - pt = a - bit
+ cyt
=
Pc
Dc
f
n
P
P
P
c
q
Nominal Interest Rate
Morningstar - Q4 2022

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