US monetary policy, 2020–23: Putting the quantity theory to the test

• Published date: 01 June 2023
• Author: Peter N. Ireland
• Date: 01 June 2023
• DOI: http://doi.org/10.1111/jacf.12567

DOI: 10.1111/jacf.12567

ORIGINAL ARTICLE

US monetary policy, 2020–23: Putting the quantity theory to the test

Peter N. Ireland

Department of Economics, Boston College, Chestnut Hill, Massachusetts, USA

Correspondence

Peter N. Ireland,Department of Economics, Boston College, 140 Commonwealth Avenue, Chestnut Hill, MA 02467, USA.

Email: peter.ireland@bc.edu

INTRODUCTION

The quantity theory of money identif‌ies large and persistent

movements in money supply growth as the principal driving force

behind large and persistent movements in inf‌lation. Milton Fried-

man’s famous dictum that “inf‌lation is always and everywhere

a monetary phenomenon” summarizes the quantity theory most

succinctly.1

In fact, dramatic swings in money growth appear in US data

from the past several years. These can be seen in Figure 1,which

plots the year-over-year growth rates of three measures of the

money supply described in more detail below: M2, Divisia M2,

and Divisia M4. By all three measures, the US money supply grew

at rates exceeding 20% throughout 2020 and into 2021.2Money

growth slowed considerably in 2022, however, and has even

turned negative—signaling outright monetary contraction—more

recently, partially reversing the previous years’ increases.

For economists, these extraordinary movements in the money

supply—unprecedented in the post-World War II period—

provide valuable information with which to test the quantity

theory’s key implications. After taking a closer look at the data

to place the recent f‌luctuations in money growth in a broader

historical perspective, this paper uses them to estimate a small-

scale econometric model, known as the “P-star model,” that links

movements in the money stock to subsequent movements in

inf‌lation in a manner consistent with the quantity theory.

The P-star model yields, as a useful by-product, a statistical

“price gap” measure that summarizes the effects that past rates

1Friedman, Milton. 1970. “The Counter-Revolution in Monetary Theory.”Occasional Paper

No. 33. London: Institute for Economic Affairs; reprinted in Friedman Milton. 1991.

Monetarist Economics, pp.1-20. Oxford: Basil Blackwell,The quote is from page 16.

2Previousquantity-theoretic analyses of 2020’s surge in money growth can be found in Green-

wood, John, and Steve H. Hanke. 2021. “On Money Growth and Inf‌lation in Leading

Economies, 2021-2022: Relative Prices and the Overall Price Level.” Journal of AppliedCor-

porate Finance 33: 39-51; Ireland,Peter N. 2022.“The Recent Surge in Money Growth: What

Would Milton FriedmanSay?” Journal of Applied Corporate Finance 34: 65-81; Hendrickson,

Joshua R. 2023. “Is the Quantity Theory Dead? Lessons from the Pandemic.” SpecialStudy.

Arlington, VA:George Mason University, Mercatus Center; Reynard, Samuel. 2023. “Central

Bank Balance Sheet, Moneyand Inf‌lation.” Economics Letters 224: Article 111028; and Bordo,

Michael D., and John V.Duca. 2023. "Money Matters: Broad Divisia Money and the Recov-

ery of Nominal GDP from the Covid-19 Recession." Working Paper2306. Dallas: Federal

Reserve Bank of Dallas, Research Department.

of money growth have on future inf‌lation. This paper uses that

price gap measure to gauge the current stance of US monetary

policy, taking into account both 2020’s surge in money growth

and the monetary contraction that has followed. These estimates

show that the Federal Reserve’s monetary policy is now consistent

with a return to lower, more acceptable, rates of inf‌lation. More

generally, the paper argues that with reference to the P-star model

and to the quantity theory of money on which it is based, the Fed-

eral Reserve can avoid an unwelcome return to the stop-go policy

patterns that contributed to macroeconomic volatility and rising

inf‌lation throughout the 1970s.

A CLOSER LOOK AT THE DATA

Historically, the Federal Reserve has provided two measures of the

money supply. M1 includes currency and checking account bal-

ances. M2 adds savings account balances, including funds held

in money market deposit accounts, small certif‌icates of deposit,

and retail money market mutual funds. In April 2020, the Fed

lifted the last remaining regulatory restrictions that once distin-

guished checking from savings accounts and redef‌ined the M1

aggregate accordingly.3Therefore, M2 now stands as the only his-

torically consistent series on the money supply provided by the

Federal Reserve. This “off‌icial” series runs from 1959 through the

present; its year-over-year growth rates are shown in the top panel

of Figure 1.

The M2 monetary aggregate simply adds together the dollar

value of funds held in its various component assets, with-

out recognizing that currency and checking account balances

are more liquid than certif‌icates of deposits and money mar-

ket mutual funds shares. In 1970, Milton Friedman and Anna

Schwartz envisioned a more sophisticated approach to monetary

aggregation:

In brief, the general approach consists of regarding

each asset as a joint product having different degrees

3See Ireland (2022), p.78, for a more detailed discussion of the gradual changes in regulation

that f‌irst blurred, then f‌inally removed,the distinction between checking and savings accounts.

42 © 2023 Cantillon & Mann.J. Appl. Corp. Finance. 2023;35:42–48.wileyonlinelibrary.com/journal/jacf