Reading 5. Is Quantity Theory Still Alive

The Economic Journal, 126 (March), 442–464. Doi: 10.1111/ecoj.12336 © 2015 Royal Economic Society.
Published by John Wiley & Sons, 9600

Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.
IS QUANTITY THEORY STILL ALIVE?*

Pedro Teles, Harald Uhlig and Jo~
a o Valle e Azevedo
This article investigates whether the quantity theory of money is still alive. We demonstrate three
insights. First, for countries with low inflation, the raw relationship between average inflation and the
growth rate of money is tenuous at best. Second, the fit markedly improves, when correcting for
variation in output growth and the opportunity cost of money, using elasticities implied by the
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theories of Baumol–Tobin and Miller–Orr. Finally, a subsample characterised by the adoption of
inflation targeting shows considerably less inflation variability, worsening the fit of a one-for-one
relationship between money growth and inflation.
One of the most established folk wisdoms in monetary economics is a relationship,

which in its practical version for monetary policy might be stated as follows: long-run
inflation is related one-for-one with long-run money growth. This ‘quantity theory’
relationship seems firmly established at least since Friedman (1956) and Lucas (1980).
This article takes a cross-section of countries from 1970 to 2005 and re-investigates the
relationship between money growth and inflation. We demonstrate three insights. First,
for countries with low inflation, the raw relationship between average inflation and the
growth rate of money is tenuous at best. Second, the fit markedly improves, when
correcting for variation in output growth and the opportunity cost of money, using
elasticities implied by money demand theories of Baumol–Tobin and Miller–Orr. Finally,
the sample after the implicit or explicit adoption of inflation targeting (IT) shows
considerably less inflation variability, worsening the fit of a one-for-one relationship
between money growth and inflation but maintaining a low residual variance.
To demonstrate these insights, we provide a series of graphs and tables. We start by
showing that, for countries with moderate inflation, the raw relationship between
money growth and inflation is tenuous or even non-existent. Quantity theory suggests
taking into account the growth rate of real GDP. Additionally, monetary theory points
out the dependence of velocity on yields. The correction for GDP growth alone turns
out not to help. However, the correction for a yield effect has a remarkable impact.
Indeed, one would expect a rise in nominal yields to increase the opportunity cost of
holding money and thus lead to a reduction in the real quantity of money per real unit
of output. This should translate to either lower nominal money growth or higher
inflation. Lucas (2000) has documented a rather tight fit of the ratio of the real
quantity of money to real output vis- a -vis the yield on government bonds, which
furthermore is close to a relationship predicted by theories on the transaction demand
for money (Baumol, 1952; Miller and Orr, 1966; Tobin, 1956). Taking into account the
relationship suggested by Lucas, we demonstrate that the fit between money growth
* Corresponding author: Pedro Teles, Banco de Portugal, DEE, Av. Almirante Reis 71, 1150-012, Lisbon,
Portugal. Email: [email protected].
Uhlig’s research has been supported by the NSF grant SES-0922550 and by a Wim Duisenberg fellowship at
the ECB. Teles gratefully acknowledges the financial support of FCT. Uhlig has an ongoing consulting
relationship with a Federal Reserve Bank, the Bundesbank and the ECB. The views here are entirely our own.
[ 442 ]
[ M A R C H 2016] IS QUANTITY THEORY STILL ALIVE? 443
and inflation indeed markedly improves. An even better fit is obtained when using the
(lower) elasticity value suggested by Miller and Orr (1966). We finally estimate the
relationship and find just a small improvement over the Miller–Orr specification.
The estimation of money demand has been under debate recently. The 1990s and
2000s have been testing decades for it, see in particular the discussion in Ball (2001),
Carlson et al. (2000), Coenen and Vega (2001), Ireland (2009), Lucas and Nicolini
(2015), Sargent and Surico (2011) and Teles and Zhou (2005). Motivated mostly by
Ireland (2009) and Sargent and Surico (2011), we split the data into two parts,
choosing as split point for each country the dates coinciding with the implicit or
explicit adoption of inflation targeting.1 We also consider 1990 as an alternative

breaking point, which could reflect changes in financial arrangements and regulation.
Teles and Zhou (2005) and Lucas and Nicolini (2015), consider 1980 as a data break
for the US, focusing on the effects on monetary aggregates of banking deregulation
introduced after 1980.2 Those changes together with the financial innovation in the
1990s associated with the development of electronic payments suggest that M1 might
not be the most appropriate monetary aggregate to use in the later part of the sample.
The relationship between money growth and inflation has become hard to pin down
during the second part of the sample. Generalised inflation targeting at low inflation
rates, by considerably reducing the dispersion of inflation across countries, has made it
virtually impossible to establish the one-to-one relationship between average inflation
and the growth rate of money implied by quantity theory. This has also been argued by
Sargent and Surico (2011) using US time series data, in a recount of Whiteman’s
(1984) arguments.
Another feature of the second part of the sample is that the interest elasticity of the
money demand is also harder to estimate and is lower than in the earlier sample. One
of the reasons for the difficulty in the estimation is the lower variability in interest rates.
Reasons for the lower elasticity are beyond the scope of this article. They could involve
the shape of the money demand as in Ireland (2009) or the choice of the monetary
aggregate as in Teles and Zhou (2005) or Lucas and Nicolini (2015). As it turns out,
the issues with the estimation of the interest elasticity in the second part of the sample
are not relevant for the purposes of our exercise. Given the lack of variation in
inflation and interest rates, the interest elasticity of the money demand does not make
a significant difference.
Investigating international cross-sections of countries to analyse the evidence on the
quantity theory of money has obviously been done before, notably by McCandlees and
Weber (1995), restated in Lucas (1996). We build up on that literature. More recent
literature such as Assenmacher-Wesche and Gerlach (2007), using information on the
interest rate, and Benati (2009) find a long-run relationship between money growth and
inflation for several countries but do not exploit the cross-section evidence as we do.
The outline of the article is as follows. Section 1 provides a basic perspective on the
cross-country data. Section 2 describes a simple model that allows for additional
‘corrective’ terms. Section 3 examines the issue of subsample instability. The data are
1
We thank a referee for this suggestion.
2
The Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn–St Germain
Depository Institutions Act of 1982.
© 2015 Royal Economic Society.
444 THE ECONOMIC JOURNAL [MARCH
described in Appendix A. Online Appendices and a .zip file provide further graphs and
tables, as well as the data used and the programs for calculating all results.
We conclude that quantity theory is still alive. Whether it should be used as a guide to
long-term monetary policy is more debatable and certainly beyond the scope of this
article. Woodford (2008) has argued that there is no independent role for tracking the
growth rate of money, if a central bank is already willing and able to stabilise inflation
rates at short and medium-term horizons, without making an explicit use of monetary
aggregates. The practice of central banks seems to be reassuring, that it is possible to
keep inflation low using, as it appears to be the case, some form of interest rate feedback

rule. However, theory is more sceptical about that capacity, pointing out that local
determinacy does not imply uniqueness (Benhabib et al., 2001). In particular an interest
rate feedback rule could be ineffective in raising inflation from very low inflation at the
zero bound. The tracking of money supply could be a means of avoiding that policy trap
(see also Atkeson et al., 2010, as well as the analysis in Fischer et al., 2006).
1. The World
Teachers of intermediate macroeconomics may have consulted Barro (1993, 2007) in
order to teach students the relationship between money growth rates and inflation. His
Figure 7.1 in the 1993 edition shows a large sample of countries, and plots this
relationship, having calculated the growth rates of money and prices from, typically,
the 1950s to 1990. The Figure is reproduced here as Figure 1: one apparently gets a
nice fit to the 45 degree line.
However, that picture turns out to be misleading and mainly driven by high inflation
countries. Concentrating on the subset of countries we analyse, whose inflation rates
80
70
Inflation in Percent per Year
60
50
40
30
20
10
0
0 20 40 60 80
Money Growth in Percent
Fig. 1. Money Versus Inflation per Year

Notes. This figure, which just restates figures drawn in Barro (1993, 2007), Lucas (1996) or
McCandlees and Weber (1995) shows the relationship between average monetary growth rates
and average inflation in a sample of 79 countries. The data is from Barro (1993). Also drawn is
the 45 degree line: It seems that, indeed, long-term monetary growth is synonymous with long-
term inflation.
2016] IS QUANTITY THEORY STILL ALIVE? 445
1970*−2005
Not Corrected
10
PT
ES KR
8
NZ
AU
6
Inflation
IT
DK
CA

US IE
FR
4
AT FIN
CH DEJP UK
NL
2
0
0 5 10 15 20
Money Growth
Fig. 2. Money Growth and Inflation in Low Inflation Countries

Notes. This figure is similar to Figure 1, but restricts attention to only those countries in our
sample whose average inflation rate was below 12% in the period 1970–2005. The inflation
measure is consumer price index (CPI) inflation and the monetary aggregate is M1. Average CPI
inflation is plotted vis-
a -vis average M1 growth. Averages of the variables are from 1970 (or later if
data is unavailable) until 2005. Instead of a tight relationship between monetary growth and
inflation, one can just see a cloud below the 45 degree line. 1970* denotes from 1970 or
whenever first available.
were all below 12%, the points no longer assemble nicely around a straight line, but
produce a rather randomly looking scatter plot with all the points below the 45 degree
line, see Figure 2. The question is thus: is the relationship between money growth and
inflation too loose to be of any relevance for low inflation countries?
These pictures should be considered disturbing by anybody who believes in a tight
relationship between money growth and inflation and bases monetary policy advice on
such a belief. Additional issues may be of relevance at low rates of inflation, however. In
particular, GDP growth, changes in interest rates, technological progress in transaction
technologies as well as production may make a difference. We next discuss how these
can be taken into account.
2. Correcting the Quantity Theory Relationship

In deriving an equilibrium money demand relationship, we follow the simple analysis
in Attanasio et al. (2002).3 A (representative) agent needs transaction services
proportional to real consumption ct, which are produced with time st and real money
balances mt = Mt/Pt, according to:
3
See also Lucas (2000).
st ¼ lðAt1 ct ; mt Þ; (1)
where At measures progress in the transactions technology.
Given ct, the agent will want to minimise the cost of transactions, wtst + Rtmt, subject
to (1), where wt is the wage rate and Rt is the opportunity cost of holding money, the
nominal interest rate. The marginal condition:
wt lm ðAt1 ct ; mt Þ ¼ Rt (2)
will have to hold.
Let the transactions function l be:

lðc; mÞ ¼ gc a m b (3)
for some g, a and b, with b < 0 and g > 0. When a = 1 and b = 1, the form for the
transactions technology can be justified by assuming, inspired by Baumol (1952) and
Tobin (1956), that the consumer spends cash holdings intended for the purchase of
the good at a constant rate ct per unit of time. ct/mt is the number of times cash
balances for transactions of the good are exhausted and must be restored, the number
of trips to the bank. This time cost is a constant g. The Miller and Orr (1966)
specification amounts to l(c,m) = g(c/m)2, i.e. a = 2 and b = 2.
The marginal condition (2) can be written as gbwt Ata cta mtb1 ¼ Rt . In logs, the
condition is:
1 a 1 a
log mt ¼ B log Rt þ log ct þ log wt log At ; (4)
1b 1b 1b 1b
with B = log (gb)/(1b).
To make contact with the data, we wish to examine a panel of countries i = 1, . . ., N
and a time period t = 1, . . ., T. For a country i and a variable xi,t, generally denote
the sample growth rate of that variable between time one and time T with
Dxi ¼ ðlog xi;T log xi;1 Þ=T :
Equation (4) implies:
1 a 1 a
DM
i Di ¼
P
DRi þ Dci þ Dwi DA ; (5)
1b 1b 1b 1b i
in which DM i is the average growth rate of the stock of nominal money in country i and
DPi is the average inflation in that country. This suggests that the long-run relationship
between money and prices ought to be corrected by the variation of nominal interest
rates and by the growth rates of consumption, as a measure of transactions, real wages
and technical progress in transactions. There are implications from the transactions
technology for the relevant elasticities. For instance, for the Baumol–Tobin, with a = 1
and b = 1, the interest elasticity would be one half, and so would be the elasticity to
the growth rate of consumption. For the Miller–Orr technology (a = 2 and b = 2),
the two elasticities are one third and two thirds, respectively.
Before taking the theoretical relationship to the data, we take two further steps. The
first is to use balanced growth to impose that the average growth rate of consumption is
y
equal to the growth rate of real wages, and to the growth rate of output, Di :
y
Dci ¼ Dwi ¼ Di : (6)
Notice that with this assumption, the relationship between money and prices is to be
corrected by the growth rate of output with an elasticity of (1 + a)/(1 b). This long-
run elasticity is equal to one for both Baumol–Tobin and Miller–Orr technologies.4
The second step is to assume that the cross-country level shift in the transactions
technology can be captured by a random fixed effect:
a
DA ¼ i ; (7)
1b i
y
where we assume, and this is a strong assumption, that ei is independent of Di and DRi .
With this assumption as well as with (6), we obtain the empirical specification:5

y
DM
i Di ¼ cDi aDi i ;
P R
(8)
where
1þa 1
c¼ and a ¼ : (9)
1b 1b
One can now either proceed to estimate (8), noting that the two structural parameters
a and b are identified per (9), or one can directly measure the fit of that equation for
given specifications of the transaction technology. In particular, we note that:
y 1 R
DM
i Di ¼ Di Di i
P
(10)
2
for the Baumol–Tobin specification and
y 1 R
i Di ¼ Di Di i ;
DM P
(11)
3
for the Miller–Orr specification.
2.1. Data and Results

For our investigation, we have used data for all OECD countries, drawing on statistics
from the IMF, the OECD, the European Commission, the ECB and other sources. We
excluded countries with average inflation above 12%, transition countries and
countries with missing data. We focus on annual data from 1970 until 2005. The
reason not to include data after 2005 is to avoid the zero bound episode in the
aftermath of the financial crisis. At zero interest rates, money and bonds are perfect
substitutes and the demand for money is not uniquely pinned down. Put differently, if
we are to find changes in the relationship between money growth and inflation within
our sample, they will not be due to zero bound considerations. We used CPI inflation,
short rates as well as M1 for all countries.6 We agree that more appropriate aggregates,
with instruments more closely related to transactions motives, such as money zero
4
The unit elasticity of the money demand to output in typical formulations of the money demand, as in
Lucas (2000), is a feature of long-run growth.
5
The specification in (8) is log-log in contrast to a semi-log specification. See the discussion in Bailey
(1956) and Ireland (2009).
6
In earlier versions of this article, we also experimented with M2 and M3, as well as long rates: the data problems
there were generally greater, but preliminary results looked rather similar to the results documented here.
1970*−2005
15
10
PT
Inflation
ES KR
NZ
AU

IT
DK
5
US CAIE
FR
AT FIN JP
CH DE UK
NL
0
0 5 10 15
Corrected Money Growth
Fig. 3. Corrected for GDP Growth

Notes. Corrected money growth rate here is average M1 growth minus average real GDP growth.
Average CPI inflation is plotted vis-
a -vis corrected money growth. For each country, the average
of the variables is from 1970 (or later if data is unavailable) until 2005. The points scatter loosely
around, but mostly below the 45-degree Line. 1970* denotes from 1970 or whenever first
available.
maturity (MZM) could be used. Unfortunately, they are not readily available and are
reliable only in a few countries. The same applies to divisia indices (Barnett, 1980;
Barnett and Serletis, 2000). More information on the data as well as explanations for
the short codes used to denote countries, can be found in Appendix A.
Figure 3 ‘corrects’ the money growth rate by subtracting the GDP growth rate. The
points scatter loosely below the 45-degree line. Figure 4 removes the yield effect with the
coefficient of 0.5 on the interest rate change as suggested by the Baumol–Tobin
specification (10), as well as suggested by Lucas (2000) and close to the one estimated for
Italy by Alvarez and Lippi (2009). The correction with the yield considerably improves
the fit, shifting the data points upwards, that now line up nicely along the 45-degree line.
Figure 5 contains the result for the Miller–Orr specification, while Figure 6 finally
contains the correction implied by estimating (8) with c = 1 and including a constant,
using as variables the averages from 1970 until 2005, per ordinary least squares.7
Information about the quality of fit, by calculating an R2 and the variances of ei is in
Table 1, including results for subsamples, see Section 3. The results from the regression
imposing c = 1 are in Table 2, including results for subsamples, see also Section 3. Full
results with c unrestricted can be found in the online Appendices. The estimated interest
rate elasticity is below the Baumol–Tobin and Miller–Orr values. For the full sample, the
7
We provide results including a constant, which would not be motivated by the theory above but instead
by the desirability to control (if one thinks in the equation in levels) for movements in velocity not captured
by changes in the interest rates, due, e.g. to financial innovation.
1970*−2005
15
10
PT
Inflation
ES KR
NZ
AU

IT
DK
5
CA
FR IE
US
AT
FIN
CHJP DE UK
NL
0
0 5 10 15
Fig. 4. Corrected for Yield – Baumol–Tobin

Notes. Baumol–Tobin: corrected money growth rate here is average M1 growth minus average real
GDP growth plus the average growth of a nominal interest rate, divided by two, following (10).
Average CPI inflation is plotted vis-
a -vis corrected money growth. For each country, the average of the
variables is from 1970 (or later if data is unavailable) until 2005. The correction with the yield
improves the fit to the 45-degree Line. 1970* denotes from 1970 or whenever first available.
Baumol–Tobin fits worse than the other three specifications that control for yields, all of
which provide essentially the same quality of fit.
We complement this analysis with the estimation of the following panel cointegra-
tion model:

Mit
log ¼ a0;i þ a1 t þ c logðYit Þ a logðRit Þ þ uit ; (12)
Pit
with

logðYit Þ
D ¼ k0;i þ vit ; (13)
logðRit Þ
0
where D is the first-difference operator. wit := (uit,vit) is possibly serially correlated but
assumed independent across i = 1, . . ., N. (1, c,a) is a cointegrating vector and the
equilibrium error (log(Mit/Pit) c log(Yit) a log(Rit)) is allowed, in its most
general configuration, to have country-specific fixed effects and a common time
trend. Interestingly, panel tests indicate clearly that log(Mit/Pit), log(Yit) and log
(Rit) are integrated of order one and cointegrated.8 Next, we consider several
variations of the dynamic OLS (DOLS) and fully modified OLS (FMOLS) panel
8
We employ the tests implemented in E-views due to Breitung (2000), Choi (2001), Hadri (2000), Im et al.
(2003), Levin et al. (2002) and Maddala and Wu (1999) to test for unit roots and those due to Kao (1999),
Maddala and Wu (1999) and Pedroni (1999, 2004) for cointegration.
1970*−2005
15
10
PT
Inflation
ES KR
NZ
AU

IT
DK
5
US CA
IE
FR
ATFIN
CHJP DE UK
NL
0
0 5 10 15
Fig. 5. Corrected for Yield – Miller–Orr

Notes. Miller–Orr: corrected money growth rate here is average M1 growth minus average real GDP
growth plus the average growth of a nominal interest rate, divided by three, capturing the
transactions technology model due to Miller and Orr (1966). Average CPI inflation is plotted vis-
a-
vis corrected money growth. For each country, the average of the variables is from 1970 (or later if
data is unavailable) until 2005. The fit around the 45 degree line is better than the Baumol–Tobin
specification. 1970* denotes from 1970 or whenever first available.
estimators (Phillips and Moon, 1999; Kao and Chiang, 2000; Pedroni, 2000, 2001; Mark
and Sul, 2003). Using DOLS the uit are allowed to be correlated with at most pi leads
and lags of vit, which controls for the possible endogeneity one hardly can get rid of in
the simple regression setting. For all the details and full results of this exercise, see
online Appendices. Partial results obtained with the restriction c = 1 are in Table 1. In
this setting, the estimates of a obtained within the 1970–2005 sample are in the range
0.10–0.29, i.e. below the 0.33 of the Miller–Orr specification.
3. Subsamples
3.1. The Quantity Theory with Inflation Targeting
We now draw attention to the results before and after the implicit or explicit adoption
of inflation targeting (IT). For each country we split the full sample in IT and non-IT
periods and consider this splitting to calculate averages, run regressions with these
averages or consider (unbalanced) panel cointegration regressions. The specific dates
and justification for these choices are in Appendix A.
Starting with the corrections to average money growth, we note that in all samples
the Miller–Orr specification as well as the estimated specifications, which point to a
lower interest rate elasticity, clearly fit better than the Baumol–Tobin specification. But
what is more striking is that while the fit for all specifications in the non-IT part of the
sample is essentially as good as for the whole sample, the fit, as measured by an R2 is
1970*−2005
15
10
PT
Inflation
ES KR
NZ
AU

IT
DK
5
US CA
IE
FR
ATFIN
CHJP DE
NL
0
0 5 10 15
Fig. 6. Corrected for Yield – Estimated

Notes. Corrected money growth rate here is average M1 growth minus average real GDP growth
plus the average growth of a nominal interest rate, multiplied by an estimated elasticity, minus a
regression constant. Average CPI inflation is plotted vis- a -vis corrected money growth. For each
country, the average of the variables is from 1970 (or later if data are unavailable) until 2005. The
fit around the 45 degree line is similar to the Miller–Orr specification. 1970* denotes from 1970
or whenever first available.
Table 1
Measures of Fit and Error Dispersion
Regression based
Corrections corrections
c = 1, c = 1,
Period Not GDP a est. with a est.
benchmark corrected growth Baumol–Tobin Miller–Orr constant no constant
1970*–2005 R2 2.79 0.31 0.37 0.62 0.65 0.64

SD (ei) 4.76 2.04 1.94 1.51 1.45 1.46
SD (D log (M/P)) 2.45
1970*-IT R2 1.18 0.52 0.23 0.56 0.69 0.66
SD (ei) 4.47 2.10 2.65 2.00 1.67 1.77
SD (D log (M/P)) 3.02
IT-2005 R2 6.45 0.93 0.18 0.10 0.43 0.10
SD (ei). 5.59 2.94 2.29 2.01 1.59 2.01
SD (D log (M/P)) 2.12
Notes. R2 is calculated as 1 SSR/SST, where SSR is the sum of squared residuals, where the residuals are the
differences between average inflation and (possibly adjusted) average money growth and SST is the total
variation in real money growth). SD (ei) is the estimated standard deviation of the residuals. SD (Dlog(M/P))
is the standard deviation of real money growth. Averages of the variables are from 1970 (or whenever data are
available) until 2005, denoted 1970*–2005; from 1970 (or whenever data are available) until IT adoption,
denoted 1970-IT and from IT adoption until 2005, denoted IT-2005. Countries included: AU, AT, CA, DK,
FIN, FR, DE, IE, IT, JP, KR, NL, NZ, PT, ES, CH, US (17 observations). 1970-IT does not include DE and CH.
IT-2005 does not include JP.

Table 2
Regression Results
No constant Constant included
Preferred spec.
c=1 c=1
Period benchmark a R2 a Const. R2

1970–2005 0.26 0.64 0.34 0.44 0.65
(0.07) (0.14) (0.77)

1970-IT 0.18 0.66 0.26 0.74 0.69
(0.08) (0.10) (0.59)
IT-2005 0.33 0.10 0.01 2.51 0.43
(0.08) (0.13) (0.88)
Notes. Regression of (averages of) real money growth on real output growth and the nominal interest rate.
Standard errors below the estimates. R2 is calculated as 1 minus (sum-of-squared of residuals divided by total
variation of real money growth). Averages of the variables are from 1970 (or whenever data are available) until
2005, denoted 1970*–2005; from 1970 (or whenever data are available) until IT adoption, denoted 1970*-IT and
from IT adoption until 2005, denoted IT-2005. Countries included: AU, AT, CA, DK, FIN, FR, DE, IE, IT, JP, KR,
NL, NZ, PT, ES, CH, US (17 observations). 1970*-IT does not include DE and CH. IT-2005 does not include JP.
much worse for the IT part of the sample, as Table 1 shows. Also, not including a
constant in the regression, i.e. not controlling for movements in velocity (through a
linear trend) not attributable to movements in the short rate deteriorates dramatically
the fit in the more recent sample.
The Figures provide an even more revealing story. Figure 7 shows the results for the
Baumol–Tobin specification across samples, Figure 8 for the Miller–Orr specification,
and Figure 9 shows the results for the estimated specification.
Results for the simple regression with averages are in Table 2 and those for the panel
cointegration regression imposing a unitary output elasticity (c = 1) are in Table 3.
More complete versions of the results, including choosing 1990 as the split point, can
be found in the online Appendices.9 We should mention that, in our view, the most
appropriate specifications include a constant in the simple regression and, addition-
ally, a trend in the cointegration equation.10
We want to stress two points here. The first is that the estimated interest elasticity is
lower for the IT part of the sample. This result has been observed in the literature on
the stability of the money demand using time series data, as for example in Ireland
(2009). Part of the explanation for the low elasticity is the increasing role of money
substitutes that are not included in M1, as argued by Teles and Zhou (2005) and,
recently, also by Lucas and Nicolini (2015).
The second result, more important for our purposes, is the apparent poor fit of a
money growth-inflation relationship in the IT part of the sample compared to the non-
9
The main messages do not change if we consider that alternative split point.
10
This way we control, even if in a crude way, for movements in velocity not attributable to changes in
interest rates or output. Not including a constant in the regressions (or a trend in the cointegration
equation) has a big impact in the estimated elasticities for the IT-2005 sample due to the fact that these
movements are being attributed to the fall in interest rates over this period. This is a typical bias due to the
omission of deterministics.
1970*−2005
15 10
Inflation
PT
ES KR
NZ
AU
IT
DK
5
US IECA
FR
AT
FIN
CHJP DE UK
0 NL

0 5 10 15
1970*−IT
15
NZ
PT ES
10
Inflation
KR
AU
US CA
IT DK
FIN
UK
5
FR IE
JP AT
NL
0
−5 0 5 10 15
IT−2005
15 10
Inflation
5
IE
ES
US CH PT DE KR
NZ DKIT AU
NL
CA FRAT UK
FIN
0
−5 0 5 10 15
Fig. 7. Corrected for Yield – Baumol – Tobin

Notes. Baumol–Tobin: corrected money growth rate here is average M1 growth minus average
real GDP growth plus the average growth of a nominal interest rate, divided by two, following
(10) as well as the suggestion of Lucas (2000). Average CPI inflation is plotted vis-
a -vis corrected
money growth. For each country, the average of the variables is from 1970 (or whenever data are
available) until 2005, denoted 1970*–2005; from 1970 (or whenever data are available) until IT
adoption, denoted 1970*-IT and from IT adoption until 2005, denoted IT-2005.

1970*−2005
15 10
Inflation
PT
ES KR
NZ
AU
IT
DK
5
US CA
IE
FR
AT
FIN
CH JP DE UK
NL

0 5 10 15
1970*−IT
15
NZ
PT ES
10
Inflation
KR
AU
US CADK
IT
FIN
5
FR IE UK
JP AT
NL
0
0 5 10 15
IT−2005
1510
Inflation
5
IE
US ES CH PT DE KR
NZ DKIT AU
NL
CA FRAT UK
FIN
0
0 5 10 15
Fig. 8. Corrected for Yield – Miller–Orr

Notes. Miller–Orr: corrected money growth rate here is average M1 growth minus average real
GDP growth plus the average growth of a nominal interest rate, divided by three, capturing the
transactions technology model due to Miller and Orr (1966). Average CPI inflation is plotted vis-
a-vis corrected money growth. For each country, the average of the variables is from 1970 (or
whenever data are available) until 2005, denoted 1970*–2005; from 1970 (or whenever data are
available) until IT adoption, denoted 1970*-IT and from IT adoption until 2005, aenoted IT-
2005. The fit around the 45 degree line is better when compared to the Baumol–Tobin in all the
samples.

1970*−2005
15
10
Inflation
PT
ES KR
NZ
AU
IT
DK
5
US CA
IE
FR
AT
FIN
CH JP DE
NL

0
0 5 10 15
1970*−IT
15
NZ
PT ES
10
KR
Inflation
AU
US CA DK
IT
FIN
IE
5
FR
JPAT
NL
0
0 5 10 15
IT−2005
15
10
Inflation
5
IE
US PT
CHDE
ES KR
AU
NZ NL
ITDK
FRAT
CA
FIN
0
−5 0 5 10 15
Fig. 9. Corrected for Yield – Estimated

Notes. Corrected money growth rate here is average M1 growth minus average real GDP growth
plus the average growth of a nominal interest rate, multiplied by an estimated elasticity, minus a
regression constant. Average CPI inflation is plotted vis-a -vis corrected money growth. For each
country, the average of the variables is from 1970 (or whenever data are available) until 2005,
denoted 1970*–2005; from 1970 (or whenever data are available) until IT adoption, denoted
1970*-IT and from IT adoption until 2005, denoted IT-2005. The fit around the 45 degree line is
similar to the Miller–Orr specification.

Table 3
Panel Cointegration Regression Results
Estimation-DOLS Constant Constant and common trend
Preferred specification
Period benchmark c=1 c=1
Grouped Pooled Grouped Pooled

a a a a
1970*–2005 0.24 0.18 0.13 0.10

(0.02) (0.01) (0.02) (0.01)
1970*-IT 0.26 0.20 0.25 0.19
(0.04) (0.02) (0.04) (0.02)
IT-2005 0.25 0.17 0.06 0.02
(0.02) (0.01) (0.02) (0.01)
Estimation-FMOLS Constant Constant and common trend
Period benchmark c=1 c=1
Grouped Pooled Grouped Pooled

a a a a
1970*–2005 0.24 0.29 0.14 0.20
(0.02) (0.02) (0.02) (0.02)
1970*-IT 0.25 0.24 0.25 0.19
(0.03) (0.03) (0.03) (0.03)
IT-2005 0.22 0.34 0.05 0.13
(0.02) (0.05) (0.01) (0.05)
Notes. Estimation by DOLS and FMOLS considering country fixed-effects only and country fixed-effects and a
common time trend in the cointegration equation. In each setting we consider Grouped and Pooled
(weighted) estimation of the panel. Pooled (weighted) estimation considers cross-section estimates of the
error covariances. With FMOLS we consider heterogeneous first-stage long-run coefficients. Using DOLS the
uit are allowed to be correlated with at most pi leads and lags of vit. We choose pi according to the AIC
criterion. HAC standard errors are below the estimates. For each country, data are from 1970 (or whenever
available) until 2005, denoted 1970*–2005; from 1970 (or whenever data are available) until IT adoption,
denoted 1970*-IT and from IT adoption until 2005, denoted IT-2005. Countries included: AU, AT, CA, DK,
FIN, FR, DE, IE, IT, JP, KR, NL, NO, NZ, PT, ES, CH, US. 1970*-IT does not include DE and CH
IT part of the sample or the whole sample, see Table 1. It is still the case, however, and
very importantly so, that the residual variance, or variability around the 45 degree line
in the inflation-(adjusted) money growth plots, is comparable to the other samples.
The reason for the apparent poor fit of the quantity theory relationship in the IT
sample is that inflation is nearly the same across countries. Without variation in
inflation there can be no one-to-one relationship between inflation and money growth.
Examining Figures 7, 8 and 9 makes this point in a striking way. The explanation is
simple. Central banks have increasingly focused on achieving a low and roughly
common target for the inflation rate. Apparently, they have been successful in
achieving this goal. Central banks choose a money growth rate that offsets shocks to
the money-inflation relationship, in order to achieve their common target.
There is residual dispersion in money growth, probably due to differing experiences
in deregulation and innovation in transactions technologies, but not enough to
question the tightness of the relation as measured by the residual variance.
The fact that the quantity theory one-to-one relationship between money growth and
inflation cannot be found in the data does not mean that it is not a feature of a model
that generates comparable data. In the simple model of Section 3, if inflation was equal
to 2% for every country and if interest rates were constant over time (possibly equal to
4%), that would make it impossible to identify the relationship in the data generated
by the model, regardless of the interest elasticity. Even if the relationship is indeed a

feature of the model. In this sense, the model can trivially be used to explain the
subsample instability.
Interestingly, the recent work of Sargent and Surico (2011) makes similar points
using the time series evidence for the US, also used in Lucas (1980). They argue that
part of the difficulty in establishing a relationship between money and inflation in the
US in the more recent data is due to the policy of inflation targeting. This has reduced
the intertemporal variability of inflation, making it hard to find a one-to-one low-
frequency relationship between money growth and inflation in the US time series.
4. Conclusions
A cross-section of long-term averages for inflation and money growth plotted one
against the other as in e.g. McCandlees and Weber (1995) has those averages line up
nicely along a 45 degree line. In his Nobel lecture, Lucas (1996) claims that there is no
sharper evidence in monetary economics.11 But the evidence is by no means as sharp
when the sample excludes countries with very high inflation. For countries with
moderate inflation, the overwhelming evidence is just not there.
We use a cross-section of countries with moderate inflation to re-establish the one-to-
one close relationship between long-term inflation and money growth. For that we
need to take into account the effect of long-term movements in nominal interest rates,
according to elasticities that match the ones suggested by both theory on transactions
technologies, as in Baumol (1952), Tobin (1956), Miller and Orr (1966), and
estimation using time series data for the US and other countries. Once we take into
account the effect of movements in interest rates for the whole sample, between 1970
and 2005, what appeared to be a random scatter of points is now a 45 degree line
through the origin.12
The data are split into two subsamples with the data break coinciding with the
explicit or implicit adoption of inflation targeting. We find that for the later part of the
sample the one-to-one relation between inflation and money growth seems to
deteriorate. Such deterioration is only apparent since the residual variance is
comparable to the one found for the full sample. The reason for all this is moderate
11
‘Central bankers and even some monetary economists talk knowledgeably of using high interest rates to
control inflation, but I know of no evidence from even one economy linking these variables in a useful way,
let alone evidence as sharp as that displayed in Figure 1. The kind of monetary neutrality shown in this
Figure needs to be a central feature of any monetary or macroeconomic theory that claims empirical
seriousness’ (Lucas, 1996, p. 666)
12
For the line to be through the origin, the effect of output growth must also be taken into account.
dispersion in money growth coupled with successful inflation targeting at a low
common rate. In the later sample the variability of inflation is indeed considerably
reduced. The points seem to form an horizontal line at low inflation. With very low
variability of inflation it is hard to find any relationship between inflation and money
growth. A similar difficulty was described by Whiteman (1984) and met by Sargent and
Surico (2011) in their review of Lucas (1980). Sargent and Surico also find that
inflation targeting around low inflation, reducing its variability, made it hard to extract
from the more recent US data the one-to-one relationship that Lucas found. Our
results here complement their findings, using a cross-country analysis compared to

their US time series analysis.
Appendix A. Data Description

The list of countries included in the regressions starts from the OECD countries excluding Chile,
Iceland, Israel, Mexico and Turkey, due to high inflation during relevant parts of the sample. We
furthermore excluded Luxembourg (as it is a financial hub in small country), the UK in the
regression but not in several plots (as it became a large financial hub during this period, with the
consequence that it is an extreme outlier in all the exercises), Japan for the sample IT-2005 to
avoid zero bound considerations and the transition countries (since there is no useful data for
the purpose of the analysis here from 1970 and 1990). For all other countries, we attempted to
obtain as much reliable data as possible, dropping Belgium, Greece and Sweden due to missing
data. In the end, 19 countries remain in the sample for at least part of the calculations. Table A1
lists the country codes. An Excel file containing all the data as well as detailed remarks regarding
sources and corrections is available as part of an online Appendices to the article. Likewise, the
E-Views and Stata programs that perform all the calculations and produce the graphs are part of
the online Appendices to the article.
Table A1
Country Codes
Code Country
AU Australia
DK Denmark
DE Germany
FI Finland
FR France
IE Ireland
IS Iceland
IT Italy
JP Japan
CA Canada
KR South Korea
NZ New Zealand
NL Netherlands
NO Norway
AT Austria
PT Portugal
CH Switzerland
ES Spain
UK United Kingdom
US United States

Table A2
Beginning of Inflation Targeting Dates
Country Year of IT adoption Source and/or justification

AU 1993 Hammond (2012)
DK 1995 Nominal interest rate reaches average of subsequent period
DE 1970 Very low inflation throughout the sample
FI 1993 Bank of Finland statement
FR 1999 Adoption of the euro; no previous statement or low p
IE 1999 Adoption of the euro; no previous statement or low p
IT 1999 Adoption of the euro; no previous statement or low p

JP 2001 Hammond (2012)
CA 1991 Hammond (2012)
KR 1998 Hammond (2012)
NZ 1989 Hammond (2012)
NL 1999 Hammond (2012)
NO 2001 Hammond (2012)
AT 1999 Adoption of the euro; no previous statement or low p
PT 1999 Adoption of the euro; no previous statement or low p
CH 1970 Very low inflation throughout the sample
ES 1994 Bank of Spain statement
UK 1992 Hammond (2012)
US 1984 Onset of great Moderation, common break point
An original version of the data used was collected by Jan Auerbach, an undergraduate RA in
Berlin 2006, using EcoWin, a commercial data base, which was available and existent then. Ding
Xuan, an undergraduate RA in Chicago 2012, corrected a few entries, using IMF and World Bank
Data. A number of further issues then were dealt with by the authors. In a nutshell, the latest
version of annual CPI and real GDP data is in most instances from the IMF-IFS. As for the short
nominal interest rate the main source is also the IMF-IFS. Data from the OECD, the ECB and
from St. Louis Fed’s FRED database is also used. As for M1, we rely on FRED, the IMF-IFS and the
ECB. Euro area countries do not have an independent series for M1 for the whole sample but
data for their contribution to M1 is provided by the ECB from 1980 onwards. For Germany, the
M1 as well as the real GDP series was ‘spliced’ across unification, by extending the series
backwards using the growth rates of West Germany. Details can be found in Table A3. Since the
article at hand focuses on prices, M1, real GDP and short-term interest rates, the data regarding
M2, M3 and long-term rates would need further corrections before full use, but appears to be
sufficient to provide a ‘first pass’ at the results.

460
Table A3
Data Description
Series Freq. Countries Source Sample Description and notes

P
Consumer price index, Annual All IMF IFS 1970–2005 Data for West Germany before 1991,
All items, 2010 = 100 Series extended backwards is our
calculation

Y
Real GDP, index Annual All exc. DE IMF IFS 1970–2005
2010 = 100, SA and PT
Real GDP at 2010 Annual PT EC AMECO 1970–2005
Market prices
Real GDP at 2010 Annual DE EC AMECO 1970–2005 Data for West Germany before 1991,
Market prices Series extended backwards our
calculation
R
Nominal interest rate: Annual AT IMF IFS and ECB 1970–2005 ECB rate from 1999 onwards,
Discount rate and ECB main December 31 value
refinancing operations rate
Deposit rate Annual CA IMF IFS 1971–2005
Monetary policy interest rate Annual DK IMF IFS 1970–2005
Nominal interest rate: Annual FIN IMF IFS and ECB 1970–2005 ECB rate from 1999 onwards,
THE ECONOMIC JOURNAL

Nominal interest rate: Annual FR IMF IFS and ECB 1970–2005 ECB rate from 1999 onwards,
3-month T-bill rate and ECB December 31 value
main refinancing
Operations rate
Nominal interest rate: short Annual DE OECD, IMF IFS and ECB 1970–2005 OECD short Rate from 1970–4, T-Bill
rate, T-bill rate and ECB from 1975–98, ECB rate from 1999
Main refinancing onwards, December 31 value
operations rate
[MARCH

Table A3
(Continued)
2016]

Nominal interest rate: Annual IS IMF IFS 1970–2005
Discount rate and ECB main
Nominal interest rate: Discount rate and ECB main Annual IE IMF IFS , OECD and ECB 1970–2005 IMF Discount rate until 1999, 1992
refinancing operations rate filled by December 1992 OECD
Short rate, ECB rate from 1999
onwards, December 31 value

Nominal interest rate: Annual IT, PT, ES IMF IFS and ECB 1970–2005 ECB rate from 1999 onwards,
Refinancing operations rate
Nominal interest rate: Annual JP IMF IFS 1970–2005
Deposit Rate
Nominal interest rate: Deposit Annual KR IMF IFS 1970–2005
Rate
Nominal interest rate: call Annual NL Statistics NL and ECB 1970–2005 Statistics Netherlands December
money rate and ECB main values ECB rate from 1999 onwards,
Refinancing operations rate December 31 value
Nominal interest rate: Short Annual NZ IMF IFS, OECD 1973–2005 Short Rate OECD 1973–77, T-bill
rate and T-bill rate from 1978 onwards, hole for 1985
filled by December value of OECD
short rate
Nominal interest rate: 3 Annual GB FRED INTGSTGBM193N 1977–2005 December values from monthly series
month T-bill rate
Nominal interest rate: 3 Annual US FRED TB3MS 1970–2005 December values from monthly series
month T-bill rate
IS QUANTITY THEORY STILL ALIVE?
M
Monetary aggr. M1, National Annual US, KR IMF IFS 1970–2005
Currency, SA
Monetary aggr. M1, National Annual AU FRED MANMM101AUA189S 1970–2005 December values from monthly series
Currency, SA
Monetary aggr. M1, National Annual CA FRED MANMM101CAA189S 1970–2005 December values from monthly series
Currency, SA
Monetary aggr. M1, National Annual CH FRED MANMM101CHA189N 1970–2005 December values from monthly series
Currency, NSA
461

Table A3
462
(Continued)

Monetary aggr. M1, National Annual DK FRED MANMM101DKA189N 1970–2005 December values from monthly series
Currency, NSA
Monetary aggr. M1, National Annual GB FRED MANMM101GBA189N 1986–2005 December values from monthly series
Currency, NSA
Monetary aggr. M1, National Annual IS FRED MANMM101ISA189N 1970–2005 December values from monthly series
Currency, NSA
Monetary aggr. M1, National Annual NO FRED MANMM101NOA189N 1970–2005 December values from monthly series

Currency, NSA
Monetary aggr. M1, National Annual NZ FRED MANMM101NZA189N 1970–2005 December values from monthly series
Currency, NSA
Monetary aggr. M1, National Annual JP FRED MANMM101JPA189S 1970–2005 December values from monthly series
Currency, SA
Monetary aggr. M1, NSA Annual AT, DE IMF IFS and ECB 1970–2005 Data from ECB starting in 1980, using
December values from original
monthly series; extended backwards
using growth rates of IMF IFS
Annual Data
Monetary aggr. M1, NSA Annual ES IMF IFS and ECB 1970–2005 Data from ECB starting in 1980, using
using growth rates of IMF IFS Annual
Data. Use May 2005 instead of
THE ECONOMIC JOURNAL
December due to very large spike

Monetary aggr. M1, NSA Annual FR IMF IFS and ECB 1977–2005 Data from ECB starting in 1980, using
using growth rates of IMF IFS
Annual Data
Monetary aggr. M1, NSA Annual FIN, IE, IT, ECB 1980–2005 December values from original
monthly series. IE with large spike in
January 2003.
PT, NL We set January 2003 = December
2012 and extend series with
subsequent growth rates
[MARCH

Banco de Portugal, Universidade Catolica Portuguesa and CEPR

University of Chicago, NBER and CEPR
Banco de Portugal and Nova School of Business and Economics
Submitted: 30 September 2013

Accepted: 10 July 2015
Additional Supporting Information may be found in the online version of this article:

Appendix B. Cross-Section Regressions.
Appendix C. Panel Cointegration Regressions.
Appendix D. Additional Figures.
Data S1.
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The Economic Journal, 126 (March), 442–464. Doi: 10.1111/ecoj.12336 © 2015 Royal Economic Society.

Published by John Wiley & Sons, 9600

IS QUANTITY THEORY STILL ALIVE?*

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One of the most established folk wisdoms in monetary economics is a relationship,

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Fig. 1. Money Versus Inflation per Year

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Fig. 2. Money Growth and Inflation in Low Inflation Countries

2. Correcting the Quantity Theory Relationship

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2.1. Data and Results

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Fig. 3. Corrected for GDP Growth

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Fig. 4. Corrected for Yield – Baumol–Tobin

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Fig. 5. Corrected for Yield – Miller–Orr

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Fig. 6. Corrected for Yield – Estimated

1970*–2005 R2 2.79 0.31 0.37 0.62 0.65 0.64

© 2015 Royal Economic Society.

No constant Constant included

Period benchmark a R2 a Const. R2

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Fig. 7. Corrected for Yield – Baumol – Tobin

© 2015 Royal Economic Society.

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Fig. 8. Corrected for Yield – Miller–Orr

© 2015 Royal Economic Society.

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Corrected Money Growth

Fig. 9. Corrected for Yield – Estimated

© 2015 Royal Economic Society.

Estimation-DOLS Constant Constant and common trend

Grouped Pooled Grouped Pooled

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Estimation-FMOLS Constant Constant and common trend

Period benchmark c=1 c=1

Grouped Pooled Grouped Pooled

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Appendix A. Data Description

© 2015 Royal Economic Society.

Country Year of IT adoption Source and/or justification

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© 2015 Royal Economic Society.

Series Freq. Countries Source Sample Description and notes

© 2015 Royal Economic Society.

Discount rate and ECB main December 31 value

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Series Freq. Countries Source Sample Description and notes

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Series Freq. Countries Source Sample Description and notes

© 2015 Royal Economic Society.