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Abstract: Using a multi-country data set strong correlation are found between average growth rates of monetary aggregates and average inflation. The correlation remains strong when countries with higher average inflation rates are removed from the sample. These results confirm the strong correlation found in the traditional literature but contradict those in De Grauwe and Polan (2001) who, in a recent analysis, find that the strong link vanishes when higher inflation countries are excluded. Further analysis confirms the unit response and bears out the value of monetary aggregates as an input to the making of monetary policy.
I INTRODUCTION
Monetary theory predicts a strong long-run correlation between money growth and inflation. One strand of the empirical evidence for this assertion examines the correlation between average money growth and average inflation in a sample of countries. Calculated across a range of countries this correlation will be independent of various country specific effects and policies (e.g. the way in which monetary policy is implemented). The most quoted study of this kind is McCandless and Weber (1995). They examined data covering a 30-year period for 110 countries using three definitions of money (MO, Ml and M2). They also examined two subsamples of their data (their first subsample consisted of 21 OECD countries and their second contained 14 Latin America Countries). As regards money growth and inflation they concluded:
In the long run there is a high (almost unity) correlation between the rate of growth of the money supply and the rate of inflation. This holds across three definitions of money and across the full sample of countries and two subsamples.
McCandless and Weber give graphical evidence that the relationship between inflation and money growth is one-one but that the 45° line representing this relationship does not pass through the origin. They suggest that this implies that a central bank cannot generate a particular long-run inflation level by choosing an equal long-run growth rate for the money supply. Long-run inflation is also effected by the long-run growth rate of the economy and by changes in velocity. However, a central bank can be confident that, over the long run, a higher growth rate of the money supply will result in a proportionately higher inflation rate. Their results are broadly consistent...