A Non-Monetary Explanation for Inflation

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Milton Friedman famously opined, “Inflation is always and everywhere a monetary phenomenon in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.” However, the equation of exchange, to which Friedman strongly adhered, has three variables (money supply, output, and velocity) that combine to tautologically form price.

Much fat has been chewed over money supply inflation theories, particularly given central bank actions during the financial crisis. This article proposes a framework for understanding inflation with all four terms of the equation of exchange and finds evidence that suggests productive capacity and velocity, not money supply, have the largest impact on prices.

Figure 1: Output (nominal GDP), money supply (M2) and velocity (GDP :M2 ratio)

To quickly review the theory: National income can be more than the available money supply because each of us earns money and spends or invests most of it. This spending and investment provides income to other participants in the economy, increasing national income, whereas the quantity of money can remain fixed.

The measure of how many times a dollar circulates is velocity, which means that controlling money supply growth is not adequate to limit demand and thus price growth. A policy that targeted a purely flat money supply would be helpless to contain inflation if the participants were sufficiently motivated to transact with greater circulation of the same dollar. As Figure 1 shows, the velocity of M2 money has varied greatly, ranging from 1.577 to 2.2 over 54 years. The range represents a mammoth $6.74 trillion on the basis of today’s M2 money supply, or 40% of present nominal GDP.

Mervyn King wrote extensively about the relationship between money supply and future prices. The cross-country scattergraphs he generated clearly show a long-run relationship after about the 10-year horizon.

The US data paint a different picture. The monetary aggregate that the Federal Reserve directly controls (monetary base) is actually quite negatively correlated with future inflation. We ran a series of 20 regressions, from 1 to 20 years, comparing the trailing annualized growth in monetary base with the future annualized growth in the CPI (Figure 2).

Figure 2: Scatter graphs of Monetary Base Growth vs Future CPI Growth, from 1 to 20 years  (click to expand)

Out of 20 years, only 2 showed (slightly) positive correlations. If we viewed the relationship in a vacuum, we could perhaps conclude that the Fed’s expanding the base money supply could lower the inflation rate. But that seems logically unlikely, forcing us to search elsewhere for explanations for inflation.

King added a graph comparing money supply and price levels in four instances of hyperinflation: Austria and Hungary in 1921, Argentina in 1989, and Israel in 1995 (Figure 3).

Figure 3: Price level & money supply level in 4 hyperinflation cases

The most fascinating observation of all emerges: In each case, the price level increase preceded the money supply increase — that is, money supply rose to match the increased price level. This explanation is a substantial departure from the typical one, but when a variable lags another, it is unlikely to be a causative factor.

If we cannot explain inflation principally with monetary factors because velocity plays such a critical role, we must find a way to explain inflation with non-monetary factors. To explore this approach, we go back to the equation of exchange, MV = PQ.

Figure 4: A review of money supply measurements

To reiterate: M is the money supply (Figure 4), V is the velocity of money, P is the price level, and Q is the output level. The determinants of P and V are where the supply and demand curves meet to form Q. Thus, while Q explicitly is the supply at price P, V opaquely embeds the schedule of demand.

Figure 5: Scatterplot of the Middle:Old Age Ratio vs M2 velocity

Let’s begin by examining V and, by proxy, demand.

What compels participants in an economy to transact more frequently? One of the more obvious explanations is demographics. In 2011, the San Francisco Federal Reserve published a letter examining the ratio of two demographic cohorts — middle-aged (40s) and old-aged (60s) — against the price-to-earnings ratio, theorizing that the changes drove the marginal preferences in asset markets. Perhaps unsurprisingly, this approach also does a pretty good job of explaining the velocity of money (Figure 5).

But we can do better.

Figure 6: Scatterplots of Annualised Population Growth vs Future Annualised Inflation, from 1-20 years.

Mimicking the analysis in Figure 2, we ran a series of 20 regressions, from 1 to 20 years, comparing the trailing annualized growth in population with the future annualized growth in the CPI (Figure 6). The R² at 20 years is 0.98 — a very strong relationship that suggests population growth is the primary driver of inflation. 

Figure 7: Supply & Demand Curves

A picture of non-monetary inflation begins to emerge. But we propose that inflation be viewed in the framework of good old-fashioned supply and demand curves (Figure 7). Predict the shapes of those curves and you will predict inflation.

The Model

We can begin by taking statistical stock of what correlates best with future inflation. Although we create a simple multiple linear regression model, we logically separate out our independent variables into three categories: supply, demand, and policy (Figure 8).

Figure 8: Independent variable correlation coefficients to 1, 5 and 10 year future inflation, as well as the correlation the multiple linear regression model outputs.


Output is the product of land, labor, and capital — the primary factors of production. The supply curve is defined by the economy’s productive capacity, which the factors of production form.

We find that the biggest contributor to future inflation at all forecasting intervals is capital stock per capita, which we calculate as the cumulative sum of private investment after capital consumption per person. This supply factor poses as our measurement of the capital of the primary factors, given its convincing correlation (96%) with 10-year future inflation.

Supply is rounded out by the other major factor of production: labor. When the employment-to-population ratio moves up, more labor is available for production, which adds capacity, reducing pressure on price.

Total capacity utilization provides an estimate of how much immediate capacity in all factors of production has been utilized. Unsurprisingly, this factor has the largest correlation at the shortest forecasting interval, with declining significance as the forecasting interval is extended.


Figure 9: 20y trailing population growth vs 20y future Nominal GDP

As Figure 9 shows, the  R² between 20-year (20y) trailing population growth and future nominal GDP growth is 0.935. Future demand is clearly dictated by population growth. A net new person will, at the very least, add net new demand for their subsistence.

Figure 10: Expenditures by Age Group (2011 Consumer Expenditures Survey)

But that isn’t to say that the relationship of population to demand is static. When a worker ages into the peak-aged pool, their labor becomes newly valuable and exchangeable. Population growth shifts the demand curve immediately and, over time, across the arc of the expenditures-by-age curve (Figure 10).

The cyclical effects on inflation appear to be very muted other than in the short run. Perhaps surprisingly, the correlation between inflation and unemployment is low or nonexistent at nearly every interval. This result is probably because of the cyclical fluctuations being moderated by policymaking and such automatic stabilizers as unemployment insurance and progressive taxation. Were policy to do less to smooth out downturns in private spending, inflation would likely be more negatively correlated with unemployment. As of now, the strongest correlation is actually a leading correlation — inflation leads unemployment — which is the result of the Fed’s late reaction to inflation, particularly in the 1970s.


Policymaking, fiscal or monetary, really just shapes what trends deliver at the margin. It is less important and less statistically affecting than either supply or demand.

Figure 11: The long lag of monetary policy

Although M2 is not the strongest input, it does correlate with future inflation, and the growth of M2 is the result of policy over the midterm.

We estimate monetary policy by subtracting the fed funds rate from nominal GDP (Figure 11). This approach is preferred to simple real fed funds because of its superior explanatory power for both future inflation (best R = –0.39 for NGDP – FF versus best R = –0.27 for CPI – FF) and future recessions (best R = –0.29 for GDP – FF versus best R = –0.19).

We estimate the tightness of fiscal policy by measuring the gap between fixed private investment and the deficit net of defense (Figure 12).

Figure 12: Deficit net Defense (smaller is a larger deficit) and Fixed Private Investment net Capital Consumption

We observe that investment is the lever of cyclicality. Since the absolution of Bretton Woods, the deficit net defense has closely offset net private fixed investment. When the investment term becomes too small relative to the deficit term, the economy slows. This result has a much stronger signal for forecasting both the economy and inflation than just the deficit alone because it provides context for how big the deficit should be with respect to the level of net private fixed investment.

Contemporary Interpretation

The retiring generation of Baby Boomers is offset by the Millennial Generation coming of age. Although the expenditures of retirees decline, they still spend a slim majority of their peak expenditures while not contributing to supply. At the same time, the marginal Millennial coming of age will replace the marginal retiring Boomers’ demand, creating an excess of demand with the same level of labor (Figure 13).

Figure 13: 10y Compounded Annual Growth Rate of CPI and supply-side factor forecast

There is substitutability between factors of production. The more capital rich the economy, the less labor intensive is production. This fact is quite meaningful: The dependency ratio in the United States is possibly the best in the Western world, but it is still projected to nearly double in the next four decades. At the same time, dependency ratios in the rest of the world are projected to spike faster and further. This is the biggest story for the supply curve and, consequently, for inflation. The global depletion of peak-aged labor clearly necessitates one of two things: higher prices or higher rates of investment to form new capital.

Although the marginal Millennial coming of age provides an immediate source of labor, turning investment into new capital is not an instantaneous process. In addition, although some demand declines with consumer age and, by extension, demographic composition, residential capital stock is driven more purely by population size.

After being overinvested and hence oversupplied (evaluated with respect to the declining pace of inflation) for a decade, the Great Recession has seen a sharp decline in investment and an even larger decline in per capita investment. The great force that drove down inflation has not only paused but also reversed. In fact, the level of investment at the time of writing is still below replacement (Figure 14).

Figure 14: 1-year CPI %-y/y and the model forecast


Inflation and dual-mandate monetary policy truly leave policymakers in a Catch-22. An economy with elevated inflation probably has a real capital deficit. By increasing the cost of capital to reduce demand, formation of fixed capital is also retarded — the deficit of which is the principal determinant of inflation to begin with.

The discussion on inflation has gotten far away from its principal determinants. To return to the Friedman quote, it is easy to conclude that there is some monetary inflation. But inflation is usually and in most places a function of shifting supply and demand curves and not “always and everywhere a monetary phenomenon.” By better understanding the true drivers of inflation, we can forecast it better and manage it more effectively.

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8 comments on “A Non-Monetary Explanation for Inflation

  1. charles courtney said:

    Based upon your analysis inflation in medical care expenditures is easily explained due to the federal government’s stimulus of the demand for medical goods and services with special emphasis on hospital care when it amended Social Security in 1965 to provide Medicare Parts A and B. The federal government has never charged beneficiaries for Part A coverage that provides hospital insurance. The winter 1977 issue of Daedalus titled Doing Better and Feeling Worse: Health in the United States lamented the explosion in medical costs. The aggregate demand for medical goods and services constantly shifted to right as more and more senior (sic) citizens entered giant group major medical policy known as Medicare. The federal government also drove up cost of medical goods and services by constantly monitoring for quality control. See WSJ article dated June 26, 1990 authored by Sidney Marchasin Vice-President of Sequoia Hospital located in San Francisco. The number of patients served per day remained same while employees added to comply with federal monitoring exploded. Medicare represents gigantic transfer of money from those working to those retired. Victor Fuchs claimed that by 1978 the average Medicare beneficiary was spending more in real terms for out of pocket medical goods and services than they were prior to Medicare’s introduction.
    The inflation in Confederacy arose from inability to impose proper tax so Confederacy debased money. Inflation arises from fiscal ineptitude so government debases money. This is standard operating procedure in Antiquity.

  2. Charles Courtney said:

    Money is man’s most complicated weight or measure having metaphysical properties. By money I mean only coin or paper money. Checks, credit cards and one month T-Bills are near money. Hegel gave the correct definition of money from economist’s standpoint : as for the services to be exacted, it is only if these are reduced to money, the really existent and universal value of both things and services…in fact, however, money is not one particular type of wealth amongst others, but the universal form of all types so far as they are expressed in an external embodiment and so can be taken as things. Money values or weighs the exertions embedded in a good or service. See Friedman’s remarks about I pencil appearing in Chapter One of Free to Choose.
    The resultant money measurement produces a price. Hayek in The Use of Knowledge in Society (1945) proved the price system is a communication device. It represents an exchange of efforts between consumers and producers. What regulates price of any good or service is force of competition arising from man’s pursuit of happiness. Falsifying language distorts reality. We have never seen a competitively priced primary contract for medical goods and services for older citizens as the provider has been a not-for-profit. The federal government should be competing against private carriers. This would be a farce. Also, we have not seen a competitively priced medical education since we closed proprietary medical schools and let AMA regulate medical schools.
    Money is also a mark of power. As Hobbes remarked: These are the rights which make the essence of sovereignty, and which are the marks whereby a man may discern in what man or assembly of men the sovereign power is placed and resides. For these are incommunicable and inseparable. The power to coin money, to dispose of the estate and persons of infant heirs, to have preemption in markets. When the Athenians established their empire they imposed their weights, standards, and coinage upon their allies. The British empire would not let colonialists coin money.
    Money has cultural properties. It reflects differences such as language, geography and religion. You will not see human portraiture on Islamic or Ancient Jewish coinage as doing so violates Second Commandment. Albert Hourani in his history of Arab peoples remarks: At the same time as Arabic was introduced for purposes of administration, a new style of coinage was brought in, and this was significant, since coins are symbols of power and identity.In place of the coins showing human figures, which had been taken from Sasanians…new ones were minted carrying words alone, proclaiming the oneness of God and the truth of his religion brought by His messenger.
    C. C. Chamberlain and Fred Reinfeld in Coin Dictionary and Guide have more to say regarding money’s historical significance and cultural importance than anything an economist ever wrote due to his residing in ahistorical, timeless, seamless , mathematical world devoid of human beings.
    Chamberlain and Reinfeld note: Every coin has its setting, its historical background; it has links with religion, the art, the literature of the period…to the uninitiated, a coin is just a metal disk with heads on one side and tails on the other…To those blessed with insight and potent powers of imagination, a coin is an amulet that can awaken bygone scenes, and call up spirits from the misty past.

  3. Taylor Harris said:

    Thank you for the very interesting article. Is the data you put together for this analysis available for a more granular look?

  4. toni said:

    Is the opposite true as well? what about the relationship between population growth and deflation &/or stagnation, does it hold?

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