Money in the Era of Inflation Targeting

Abstract

This paper provides evidence that the relationship between inflation and money growth has changed as the inflation-targeting regime has progressed. During the disinflation period (mid 1980s to mid or late 1991) the correlation between inflation and money aggregates was fairly consistent with the prediction of theory. Both inflation and money growth fell sharply. In 1992, inflation was stabilised around an average of little less than 2 per cent. Since then, the correlation between money growth and inflation has been fairly weak at the permanent (trend) and the business cycle frequencies. By contrast, there is a significant correlation between money and real GDP over the business cycle. As far as base velocity is concerned, it was stable up until December 1997, but broke down in late 1998. As money growth took off in the late 1990s, velocity declined rather sharply, but these downward trends are consistent with the decline of interest rates as predicted by the quantity theory of money. The demand for real-monetary base is well behaved and interest inelastic, but this relationship also broke down in late 1998. However, both velocity-interest rate and money demand function breakdown is probably only temporary. Finally, at least until March 1999, the rate of growth of the monetary base has, on average, been consistent with a nominal GDP targeting policy of 4 per cent.