Paradox of inflation: the study on correlation between money supply and inflation in new era

Before 1990s, the relationship between money supply and inflation was positively correlated, however, from 1990 onwards, the US and other major developed countries entered into a new financial era with a typical belief that hyper money supply coexisted with lower inflation. This phenomenon is called “the paradox of inflation”. Traditional theories cannot provide reasonable explanations of this new phenomenon.

In my study, I have taken the linear filtering techniques which Lucas developed in 1980, and the recursive estimation method, as well as the chow test and F-test, and choose the data of the US, Britain, Japan, Germany, Euro area, BRICKs and some members of ASEAN, from 1960 to 2012, to study the relationship between annual rate of M2 growth and CPI inflation. The results show that in most sample developed and developing countries the positive correlation relationship between money supply and inflation began to weaken since the 1990s, and “the paradox of inflation” is now a common phenomenon.

In my paper, I attempt to provide a new explanation of “the paradox of inflation”. I conjecture that, in the past two decades, some advanced countries were becoming a “relatively wealthy society”, which means that commodity supply as well as money supply is abundant. I state that the US is a “relatively wealthy society” and try to determine what features could mark a “relatively wealthy society”.

I choose the credit growth rate of nonfinancial sectors and the ratio of dividends to investment to represent the production inclination of the business sector, and choose the income per capita and the GINI index to represent the consumption inclination of the resident sector. Then, through a semi parametric varying-coefficient regression model, I found that, in the US, when the credit growth of the business sector is under 5%, the ratio of dividends to investment is over 0.20, the per capita income is more than $30,000, and the GINI index is over 0.45, the country becomes a “relatively wealthy society”.

Base on this new explanation, I can conclude “in the relatively wealthy society, inflation is no longer a monetary phenomenon; it is a wealth allocation phenomenon”.