Money Growth and Inflation in the Long Run

The quantity theory of money says MV = PY. Here, M is the money supply. V is velocity, or how often a dollar changes hands in a year. P represents the price level, and Y is real output. V and Y stay stable over the long run. This theory works well over several years, but not week to week. When the money supply grows, inflation usually follows closely behind.

This idea supports monetary neutrality in the long run. Growth in the money supply primarily affects nominal variables, like the price level. It doesn't impact real variables, such as real output or real employment, once the economy adjusts. In the short run, money isn't neutral. That's why monetary policy can influence real GDP over a 12 to 18 month period. Long-run neutrality and short-run non-neutrality describe the same behavior of a variable over different time frames.

Hyperinflations provide strong evidence for the quantity theory. Each documented hyperinflation happens alongside a dramatic increase in the money supply. This typically occurs when a government prints money to fund spending beyond what it can cover with taxes or borrowing.