Adaptive Quantity Theory of Money

• Activity Number: 261
• Type: Contributed
• Date/Time: Monday, August 10, 2015 : 2:00 PM to 3:50 PM
• Sponsor: IMS
• Author(s): Ying Wang* and Yundong Tu and Song Xi Chen
• Companies: and Guanghua School of Management, Peking University and Peking University/Iowa State Univeristy
• Keywords: functional-coefficient cointegration ; quantity theory of money ; inflation forecast

Abstract

In this article we investigate the link between price level (P), money supply (M) and real output (Y) in the U.S. since 1959. We find that price (log(P)) is no longer in proportion with excess money supply, as measured by log(M/Y), after 2000, in contrast to what is postulated by the Quantity Theory of Money (QTM). This relationship is found unstable and depends closely on macroeconomic state variables such as the rate of unemployment. As a remedy, we generalize the notion of cointegration and allow the cointegration vector to adapt with unemployment rate, thus obtain an Adaptive Quantity Theory of Money (AQTM). AQTM is shown to more precisely describe the data and it is robust to model specification tests. Formulated in the form of Engle and Granger's (1987) error correction model (ECM), we found that AQTM outperforms the traditional QTM and other models used frequently in forecasting U.S. inflation.