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Research Note

A note on the hidden risk of inflation

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Pages 91-97 | Published online: 15 Jan 2014
 

Abstract

The continued expansionary policy of the Federal Reserve gives rise to speculation whether the Fed will be able to maintain price stability in the coming decades. Most of the scientific work relating money to prices relies on broad monetary aggregates (i.e. M2 for the United States). In our paper, we argue that this view falls short. The historically unique monetary expansion has not yet fully reached M2. Using a cointegration approach, we aim to show the hidden risks for the future development of M2 and correspondingly prices. In a simulation analysis we show that even if the multiplier remains substantially below its pre-crisis level, M2 will exceed its current growth path with a probability of 95%.

JEL Classifications:

Notes

1. A notable exception that also considers monetary base is Cuthbertson and Bredin (Citation2001).

2. The result is not sensitive to trimming between 10 and 20% of the sample at the margin. The breakpoint does change to 1991M11 when reversing the order of the data. However, our results remain robust when using that break date as start of the sample.

3. Denoting equilibrium levels of the logged variables with a star, our cointegration relationship implies that . Since the elasticity of base money and M2 is , this indicates an elasticity larger than one. That is, M2 is growing faster than Mb, resulting in an increasing multiplier if the equilibrium values rise. In other words, if you solve the cointegration relationship in the steady state to find the equilibrium multiplier, the resulting term is not scalar but a function that is positive in Mb (M2). Since the equilibrium growth rate of M2 (Mb) is positive, this implies a continuously growing equilibrium multiplier (the downward movement at the beginning of our sample is identified as movement towards the (new) equilibrium after the regime shift in 1992 rather than a change of the equilibrium itself).

4. A standard VAR that ignores the long-run relation between monetary base and M2 predicts less M2 growth than the linear trend that we employ as a benchmark. Compared to the VAR, total increase of M2 is about 60% at its maximum.

5. This assumption has been introduce to simplify the economic interpretation of the constant term in the cointegration relation. Since the equilibrium multiplier is increasing in M2 in the unrestricted model and M2 is increasing over time, our scenarios reflect an optimistic case with low unintentional M2 growth.

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