Unexpectedly Intriguing!
July 31, 2008

We could just as easily called this post "King's Birthday Math," as King Banaian marked Milton Friedman's birthday by presenting the math that underscores one of Friedman's greatest insights:

Inflation is always and everywhere a monetary phenomenon.

We'll let King take it from here:

I have been teaching intermediate macroeconomics this summer, using the textbook of our current central bank chair (along with Andrew Abel and Dean Croushore), and we just finished the chapter on money. Towards the end of that chapter we teach the relationship between inflation and growth of the money supply. There's an equation which I can try to recreate here in words:

inflation = growth in money supply - (income elasticity of money)x(growth of real GDP)

which assumes relatively stable velocity of money in the short run. Friedman had insisted that "inflation is everywhere and always a monetary phenomenon", and I suggested we use that equation to see where we are now. I tend not to make exact measurements in class, so if I do a little rounding here you can hopefully make adjustments if you want something a little more precise.

Today's GDP report for Q2 puts the growth of GDP at about 2%. Friedman had followed the quantity equation to make the income elasticity of money equal one. Other research puts the number closer to 2/3 or 0.7 (the Baumol-Tobin approach makes it the inverse of the square root of 2, which is roughly 0.71). People tend to economize on cash holdings as they become wealthier, so a result for that number less than 1 makes sense.

For money, I used M2 in class (you can look at other rates here or get the raw data and do your own; see also Mark Thoma for a primer on different velocities of money). The average growth rate appears to be around 6% for the recent data.

If you accept those data, then, what would you get? Assume the income elasticity is 2/3 and the growth of GDP is 2%, and your answer would be 4.33% inflation. Assume income elasticity is 1 and you get 4%.

Now, here's where we come in! We've taken King's formula and built a tool in which you can not only calculate the expected rate of inflation, but to do so using your own assumptions about what the correct values to use are. As an added bonus, you can also run the numbers with the latest available data. Our default data is drawn from King's discussion:

Economic Data
Input Data Values
Average Growth Rate of Money Supply [%]
Income Elasticity of Money
Annualized Growth Rate of Real GDP [%]

Expected Rate of Inflation
Calculated Results Values
Expected Rate of Inflation [%]

King has already run other estimated values:

If you use 2.7% for the long run growth rate of potential GDP as CBO estimates, an expected inflation rate for the long term of 3.4% is quite reasonable for an assumption that M2 money growth stays at current levels for some time into the future. That target inflation rate of 2% is increasingly looking like it's out the window. The Fed's gift to Friedman on this birthday should be a Fed funds rate increase at its next meeting.

Our expectation is that the Fed's Open Market Committee will give Friedman just that kind of gift at their next meeting!

Labels: , , , ,

About Political Calculations

blog advertising
is good for you

Welcome to the blogosphere's toolchest! Here, unlike other blogs dedicated to analyzing current events, we create easy-to-use, simple tools to do the math related to them so you can get in on the action too! If you would like to learn more about these tools, or if you would like to contribute ideas to develop for this blog, please e-mail us at:

ironman at politicalcalculations.com

Thanks in advance!

Recent Posts


This year, we'll be experimenting with a number of apps to bring more of a current events focus to Political Calculations - we're test driving the app(s) below!

Most Popular Posts
Quick Index

Site Data

This site is primarily powered by:

This page is powered by Blogger. Isn't yours?

Visitors since December 6, 2004:

CSS Validation

Valid CSS!

RSS Site Feed

AddThis Feed Button


The tools on this site are built using JavaScript. If you would like to learn more, one of the best free resources on the web is available at W3Schools.com.

Other Cool Resources

Blog Roll

Market Links
Charities We Support
Recommended Reading
Recommended Viewing
Recently Shopped

Seeking Alpha Certified

Legal Disclaimer

Materials on this website are published by Political Calculations to provide visitors with free information and insights regarding the incentives created by the laws and policies described. However, this website is not designed for the purpose of providing legal, medical or financial advice to individuals. Visitors should not rely upon information on this website as a substitute for personal legal, medical or financial advice. While we make every effort to provide accurate website information, laws can change and inaccuracies happen despite our best efforts. If you have an individual problem, you should seek advice from a licensed professional in your state, i.e., by a competent authority with specialized knowledge who can apply it to the particular circumstances of your case.