The Simple Macroeconometrics of the Quantity Theory And the Welfare Cost of Inflation

The quantity theory of money hypothesizes that the price level is determined through the equilibration of money supply and demand. Predicated on this causal structure, a single-equation error correction model decomposes from a larger vector autoregressive system so as to make available bounds tests for a levels relationship that are robust to the univariate integration properties of the variables. This model is estimated using three alternative money stock measures and three standard specifications for money demand. The hypothesis of a long run relationship between the levels of money, prices, and income is generally supported by a century of U.S.\ data. Across this range of models and aggregates, the classic quantity theory proposition of one-for-one associations between prices and each of money and income is best satisfied when M2 is the monetary aggregate. Based on a preferred model in which money demand is loglinear in the rate of interest, and with structural change treated by indicator saturation, the welfare cost of inflation is estimated to have ranged between 0.362 and 1.326 percent of national income at interest rates experienced by the United States during the past century.