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1. Introduction
Over the years, the quantity theory of money has been extended and refined. All versions, however, begin with the well-known equation of exchange, MV = PQ, where Q is the level of national output (real gross domestic product, GDP), P is the general price level, V is the velocity of money circulation, and M is the quantity of money. To convert this equation--actually an identity--into a theory, one of the four variables contained therein must be specified as functionally dependent on the other three. Monetarists argue that P is the dependent variable (Sprinkel 1971). Specifically, they argue that M is determined by the national monetary authority; that V is determined by a variety of both secular and cyclical factors;1 that changes in V do not consistently offset changes in M; and that Q is determined by capital, labor, and technological advances (Sprinkel 1971).
The monetarist theory of inflation is a long-run theory; it does not purport to explain short-run increases in the general price level (Hafer and Wheelock 2001). Monetarists argue that short-run inflation stabilization is not feasible and, therefore, that monetary policy should be confined to inflation concerns over a relatively long horizon.2
John Moroney (2002, p. 399) asserts that in the traditional version of the quantity theory, "... a country's long-run inflation rate increases [one-to-one] with its money growth rate. The modern wrinkle is that inflation is mitigated by real GDP growth" (emphasis added). This assertion is consistent with the famous dictum of Milton Friedman (1968, p. 18) that "... inflation is always and everywhere a monetary phenomenon, produced in the first instance by an unduly rapid growth in the quantity of money" (emphasis added). Friedman's assertion is not that an increased money growth rate is the sole cause of inflation in the long run--just the most important cause (Friedman and Friedman 1980). An increase in inflation can also be caused by a decrease in the growth rate of Q (or, theoretically, even an increase in the growth rate of V), as is easily seen by solving the equation of exchange for P and then taking logs and first differences.
After taking logs and first differences,3 Moroney (2002) obtains an estimating equation in...