A study of how money supply affects inflation. The results show that a higher quantity of money supply is not always a cause of inflation. Multiple linear regression and the GLS method were applied with the use of #Stata software for this research. However, some additional modifications are needed to improve the model's goodness of fit and more endogenous factors should be added. Future study might be: Would stimulus packages cause stagflation?

1. 1
A CROSS-SECTIONAL TIME-SERIES ANALYSIS: THE EFFECT OF
MONEY SUPPLY ON INFLATION
Huong Hoang
School of Business and Economics, SUNY Plattsburgh
hhoan001@plattsburgh.edu
Traditionally, monetary policy including money supply, interest rates, bank reserve
requirements is controlled by central banks to prevent inflation or ensure price stability. A
selection of four developed countries, namely the United States, Canada, Japan, and Korea,
was to examine the relationship between money circulation and changes in levels of general
prices (CPI), based on two theories: Quantity Theory of Money and Quantity Easing. The
study found that there is a significant correlation among inflation, short-term interest rate,
money stock, exchange rate while unemployment rate has no direct impact on inflation.
Higher quantity of money supply does not always cause higher inflation and narrow money
M1 is not a dominant factor influencing CPI. GLS estimation was applied to remove
heteroskedasticity and first-order autocorrelation in panel regression.
Keywords: Money Supply, Inflation, GLS Method, Heteroskedasticity, Autocorrelation
1. Introduction
Since inflation traditionally remains one of the dominant macroeconomic factors that greatly
impact on a country’s economic growth, it has been a hot subject throughout a long period of
time and kept continuing to be discussed in the government as well as academic research groups

2. 2
worldwide. Accordingly, the Federal Reserve believes that annual inflation rate should be at 2.0
percent in order to maintain maximum employment and price stability resulting in an economic
growth. There are various points of views about the explanation and cause of inflation from
different economic schools. This led to an ongoing struggle for the monetary authorities
especially during the financial crisis and recession period, who are central banks that control
monetary policy such as setting interest rates, banking reserve requirements and money stock.
For instance, inflation rate in the US fluctuated when the 2008 global financial crisis hit the
country, whose peak was at 5.6 percent, then surged to -2.1 percent in that Great Recession.
Stimulus packages, which increased the quantity of money supply, were offered to stimulate the
floundering economy. With that said, stimulus package offered during Covid-19 in 2020 to boost
the economic growth might cause inflation or deflation, stagflation or hyperinflation.
Thus, the purpose of this paper is to examine the effect of money supply on inflation.
This research tests whether the money supply has a directly positive effect on inflation. There are
two underlying theories used in this research: the Quantity Theory of Money (QTM) and the
Quantitative Easing (QE). QTM explains that changes in price levels are caused by the supply of
money. This indicates that an increase in the growth of money supply results in inflation.
Meanwhile, QE, based on the fundamental of QTM, is also a monetary policy in which a central
bank purchases government bonds or other financial assets in order to increase the money supply
and encourage lending and investment. A panel data including consumer Price Index (CPI),
narrow money M1, short-term interest rate, unemployment rate, and exchange rate was run with
a linear regression model to test for the impact and cause of inflation. There were also tests for
heteroskedasticity, autocorrelation, and stationary within this cross-sectional time series dataset.

3. 3
As a result, GLS method was used to remove the heteroskedasticity and autocorrelation within
the panel.
There is a positive correlation among inflation, short-term interest rate, and exchange rate
while money supply is negatively significant with inflation. Unemployment rate has an
insignificant impact on inflation. Moreover, narrow money supply is not a major determinant of
inflation rate as there is a weak correlation between money circulation and changes in level of
general prices (CPI).This paper includes six sections: Section 1 discusses literature review,
Section 3 states empirical model and estimation, Section 4 explains the dataset, Section 5
expresses empirical results, and Section 6 are discussion and concluding remarks.
2. Literature Review
Fisherian theory, also known as the “neo-quantity theory”, states that there is a mechanical and
settled corresponding relationship between changes within the quantity of money and the general
level of prices of goods and services over time. In contrast, Keynesian framework is against the
direct relationship and instead proposes an indirect correlation between money supply and price,
since it ignores the role of interest rates. In other words, this economic theory points out that the
process of cash liquidity is complicated and not direct, so changes in money stock depend on
each market modifying this framework. Keynes believed inflationary policies could help
stimulate aggregate demand and boost short-term output to help an economy achieve full
employment. The largest challenge to Fisher is the Wicksellian model indicating that stimulation
of the money supply through the central bank would falsify prices disproportionately even
though increases in the quantity of money would result in higher prices.

4. 4
Yan-liang (2012) conducted an empirical analysis on the relationship between money
supply, economic growth, and inflation from 1998 to 2007 in China in order to examine whether
excessive money supply is the cause for inflation. The study found that there is no significant
impact on inflation due to the lag of broad money supply and short-term bank interest rates in the
short run. However, in the long-term equilibrium, an increase in broad money supply positively
raises the inflation rate. Hence, Yan-liang (2012) recommended a proper control of money
supply would reduce chance of inflation, but also slow down economic growth. There is another
research on the relationship between money supply and inflation in China. Accordingly, different
types of money supply namely, money in circulation M0, narrow money M1, broad measure M2
have different sizes of the impact on inflation and they are all positively correlated to the CPI
(Dong and Shen, 2019). They noticed that there is a gradual decrease in the influence of quantity
of money on inflation. In other words, money supply has a significant impact on inflation in the
short-term but will weaken and stabilize in the long run. Furthermore, the impact of money
circulation on inflation is stronger than that of fiscal deficit on inflation.
In contrast to Dong and Shen (2019), Nguyen (2015) emphasized high level of inflation
is not caused by only monetary policy including money supply and interest rate, but also fiscal
policy when investigating effects of fiscal deficits and broad money supply M2 on inflation in
Asian countries. In agreement with Fischer, Sahay, and Végh (2002), Nguyen (2015) stated that
fiscal policy consisting of fiscal deficits and government expenditure is one of the major
determinants of high inflation. Meanwhile, increase in quantity of money does not inevitably
cause inflation even all of them are positively correlated with inflation.
When there are changes in the demand and supply sides, price level as well as interest
and exchange rates will be affected (Bhattarai, 2011). Specifically, based on correlation matrix,

5. 5
there is a positive correlation among inflation (CPI), exchange rate against US dollar, treasury
bill rate, growth rate of money supply, and unemployment while a contradiction with economic
growth rate (GDP) and CPI in the UK. Since these simple correlations casted doubt on the
accuracy, ILS, 2SLS and 3SLS estimations were used instead to classify these relationships. The
author concluded that there is a significant relation between the growth rate of money supply and
inflation. The higher the growth rate of money supply, the higher inflation will be. Also,
depreciation of currency and higher interest rates contribute to an increase in inflation. Among
all of exogenous factors, quantity of money remains a significant determinant of inflation as well
as economic growth rate (Bhattarai, 2011).
Noticeably, adding to the Bhattarai’s finding, Bello and Saulawa (2013) found that there
is a bidirectional relationship between money supply and inflation, income growth, and inflation
and interest rate and inflation, which were based on the Granger causality test. The research
applied a cointegration method, VAR model, and Granger causality test and expressed there is no
long run relationship among money supply, interest rate, income growth, and inflation rate in
Nigeria from 1980 to 2010. But in the short run, those exogenous variables all granger cause of
inflation (Bello and Saulawa, 2013).
Empirical results on a study for rising prices in Saudi Arabia throughout the period of
2000 and 2016 depict different opinion to Bello and Saulawa (2013) and support the Fisherian
theory. Apart from unemployment, money supply, fixed exchange rate against US dollar, oil
prices, import and export value are statistically significant and have positive effect on inflation
(Naseem, 2018). Noticeably, money supply is one of the most potential influences on inflation,
which is the same as Dong and Shen’s findings (2019). In addition, Ofori et al. (2017) develops a
theoretical model proposing that the growth of money supply and real GDP are the major factors

6. 6
impacting on inflation in Ghana based on an Ordinary Least Squares in both short-term and long-
term.
However, according to Zhang (2018), although there is a long-term equilibrium
relationship among narrow money, broad measure, and inflation (CPI), money supply is not a
dominant factor in explaining the cyclical inflation in China. This means higher money supply
does not lead to high inflation in this country.
3. Empirical Model and Estimation
The empirical analysis of this paper was carried out through panel data. Its main objective is to
examine the effect of money supply on inflation represented by changes in monetary policy,
unemployment and exchange rates. At first, a semi-log right form of all exogenous variables in
this study was generated in order to avoid heteroskedasticity, since there were 116 missing
values for CPI in this form, which was based on Yan-liang’s model (Yan-liang, 2012).
𝐶𝑃𝐼 = 𝛼0 + 𝛼1 ln 𝑅 + 𝛼2 ln 𝑀1 + 𝛼3 ln 𝑈𝑛_𝑅 + 𝛼4 ln 𝐸𝑥_𝑅 (1)
Where CPI : changes in price levels (%)
ln 𝑅 : short-term interest rates (%)
ln 𝑀1 : narrow money supply (billions of dollars)
ln 𝑈𝑛_𝑅: unemployment rate (%)
ln 𝐸𝑥_𝑅: exchange rate against US dollar
𝛼0, 𝛼1, 𝛼2, 𝛼3, 𝛼4 ∶ estimate coefficient for each independent variable
However, most of research papers mentioned above used linear regression; thus, multiple
linear regression was run as an empirical model for this study.
𝐶𝑃𝐼 = 𝛽0 + 𝛽1𝑅 + 𝛽2𝑀1 + 𝛽3𝑈𝑛_𝑅 + 𝛽4𝐸𝑥_𝑅 (2)

7. 7
Where CPI : changes in price levels (%)
R : short-term interest rates (%)
M1 : narrow money supply (billions of dollars)
𝑈𝑛_𝑅 : unemployment rate (%)
𝐸𝑥_𝑅: exchange rate against US dollar
𝛽0, 𝛽1, 𝛽2, 𝛽3, 𝛽4 ∶ estimate coefficient for each independent variable
Then the Hausman test was used to figure out whether fixed effect or random effect fits with
model (2). Groupwise heteroskedasticity was detected with the use of the Modified Wald test in
the fixed effect regression model. In addition, since this is panel data, autocorrelation might
occur; hence, serial correlation test was carried out as well as a unit-root test was used to
examine if the model is stationary or not. After the robustness, GLS method was implemented
which was replaced for the regression mentioned above in order to remove autocorrelation and
heteroskedasticity errors.
4. Data
For this research, four developed countries, namely the United States, Canada, Japan, and Korea,
were chosen in order to reduce the heteroskedastic nature of the countries selected in the sample.
The study is entirely based on secondary data, which has been obtained from the Organization
for Economic Cooperation and Development (OECD). In this paper, monthly data set for a
period of 15 years from 2003 to 2018 was used and the semi-log right and multiple linear
regression were applied as empirical models for this panel regression analysis. The endogenous
factor is the inflation, measured as changes in price levels CPI (%). Inflation measured by CPI
(2015=100) is defined as the adjustment in the prices over time of a batch of goods and services

8. 8
purchased by particular groups of households. There are four independent variables used in this
model: 1 – Narrow money supply (M1 – billions of dollars), 2 – Short-term interest rate (%), 3 –
Unemployment rate (%), 4 – Exchange rate against US Dollars (%). The expected coefficient
signs for M1, short-term interest rate, and exchange rate are positive while there is a negative
correlation between unemployment rate and inflation rate.
Table 1 is a descriptive statistics summary of all variables used in this panel data which is
highly balanced without any missing values.
Table 1. Descriptive Statistics of Variables
Variable Observation Mean Std. Deviation Min Max
CPI 768 1.654685 1.398337 -2.5 5.904135
ST Interest Rate 768 1.702134 1.574128 .05 6.03
M1 768 76.95958 26.3182 35.94577 133.0836
Unemployment Rate 768 5.609766 2.400417 2.3 12.1
Exchange Rate 768 302.7994 467.8323 .9553 1449.616
According to Table 2, short-term interest rate, narrow money, and exchange rate are
statistically significant with p value less than 0.05 except for unemployment rate. While the
positive of inflation (CPI) with short-term interest rate and exchange rate is theoretical
justifiable, narrow money M1 negatively impacts inflation as unexpected. Additionally, a
positive relationship of the short-term interest rate with M1 and exchange rate is predicted.
Similarly, unemployment rate decreases when there is an increase in the narrow money supply.
Table 2. Pearson’s Correlation
Variable CPI
ST Interest
Rate
M1
Unemployment
Rate
Exchange
Rate
CPI 1.0000
ST Interest Rate 0.5999* 1.0000
M1 -0.3749* -0.5557* 1.0000
Unemployment Rate 0.0243 -0.0251 -0.3204* 1.0000
Exchange Rate 0.2793* 0.4155* -0.0373 -0.5518* 1.0000
Significant level: * - p < 0.05

9. 9
5. Empirical Results
With the Hausman test, a fixed-effects regression was carried out on the linear model (2).
Because R-square is only 20.70%, the model is not fit. In other words, the variability of variable
those exogenous variables do explain very well the variability of the dependent variable CPI
(Table 3). The regression model has an F-statistic of 66.23 with a p value greater than F test,
indicating the regression model is a better model than an intercept-only model. Regardless of the
goodness of fit, short-term interest rate and exchange rate are positively correlated with inflation
while narrow money M1 has a reverse effect on CPI. Based on Table 3, linear regression model
(2) is represented below with a drop of unemployment rate and added coefficient estimates:
𝐶𝑃𝐼 = .0615953 + .3695353𝑅 − .0034301𝑀1 + .0040557𝐸𝑥_𝑅 (3)
Table 3. Fixed-effects Regression
Descriptive Statistics
R-square 0.2070
F test 66.23
Prob > F 0.0000
CPI Coefficient Std. Error t P > | t | [95% Conf. Interval]
ST Interest Rate .3695353 .0362479 10.19 0.000 .2983776 .440693
M1 -.0034301 .0017251 -1.99 0.047 -.0068166 -.0000435
Exchange Rate
Rate
.0040557 .0007545 5.38 0.000 .0025746 .0055369
_cons .0615953 .3082862 0.20 0.842 -.543597 .6667876
However, since the goodness of fit is relatively low and cross-sectional time series may
have heteroskedasticity and autocorrelation errors in its model, the Modified Wald test, Levin-
Lin-Chu unit-root test, and Wooldridge test were applied in this model in order to examine
heteroskedasticity, stationarity, and first-order autocorrelation, respectively. As a result, the fixed

10. 10
effect linear regression model was detected as heteroskedastic and autocorrelated, but stationary
because all null hypotheses were rejected. Therefore, model (3) is not accepted.
With the purpose of removing first-order autocorrelation and heteroskedasticity, Feasible
Generalized Least Squares (FGLS) method was used to replace for the existing model (3). Then,
the panel is homoscedastic and has no autocorrelation as reported. The directions for all
exogenous variables with the inflation still remain the same (Table 4).
Table 4. Cross-sectional Time-series FGLS Regression
CPI Coefficient Std. Error z P > | z | [95% Conf. Interval]
ST Interest Rate .4757711 .0349296 13.62 0.000 .4073104 .5442318
M1 -.0039998 .0019016 -2.10 0.035 -.0077269 -.0002726
Exchange Rate
Rate
.0001614 .0000978 1.65 0.099 -.0000302 .0003531
_cons 1.103799 .1841096 6.00 0.000 .742951 1.464647
Thus, after the robustness, a new regression model is represented as below:
𝐶𝑃𝐼 = 1.103799 + .4757711𝑅 − .0039998𝑀1 + .0001614𝐸𝑥_𝑅 (4)
Holding other independent variables constant, one percent increase in the short-term
interest rate will lead to an increase in inflation by 0.4758. Similarly, exchange rate shrinks down
by 1% will raise inflation higher by 0.016%. At the same time, a billion of dollars causes a
decrease in inflation (CPI) by 0.39998%.
6. Discussion and Concluding Remarks
The results are similar to a study determinants of Saudi Arabia’s inflation (Naseem, 2018), which
indicate unemployment does not directly predict inflation rates in these four countries.
Meanwhile, a positive relationship of inflation with short-term interest rate and exchange rate is
supported, but the correlation between money supply M1 and inflation goes against the
underlying theories, namely Quantity Theory of Money and Quantity Easing. There is a

11. 11
significant relationship between these two factors, but the direction is opposite. This difference
could be explained by the difference between reviewing developing countries and testing
developed nations. Also, it could be accepted based on the movements of inflation rate and
money supply when stimulus packages were offered in the US during the 2008 global financial
crisis (Exhibit 1). It shows a negative direction between change in broad money supply and
change in inflation rate, which is based on Keynesian theory stating there is no direct proportion
between money supply and inflation. Moreover, narrow money supply is not a major determinant
of inflation rate as there is a weak correlation between money circulation and changes in level of
general prices (CPI).
For future research, in order to improve the goodness of fit, more independent variables
would be used such as import and export values, oil prices (Naseem, 2018), income growth
(Bello and Saulawa, 2013) and other monetary factors. In addition, a lag model would be carried
out in future study to test whether previous changes of one variable could lead to a current
change in another variable (Bhattarai, 2011).
Exhibit 1. Annual growth rate vs. Inflation rate vs. M2 growth rate in the US

12. 12
References
Bello, M. Z., & Saulawa, M. A. (2013). Relationship between Inflation, Money Supply, Interest
Rate and Income Growth (Rgdp) in Nigeria 1980-2010. Journal of Economics and
Sustainable Development, 4(8), 7–13.
Bhattarai, K. (2011). Impact of exchange rate and money supply on growth, inflation and interest
rates in the UK. International Journal of Monetary Economics and Finance, 4(4), 355.
doi: 10.1504/ijmef.2011.043400
Naseem, S. (2018). Macroeconomics Determinants of Saudi Arabia's Inflation 2000-2016:
Evidence and Analysis. International Journal of Economics and Financial Issues, 8(3),
137-141. doi: 10.4236/am.2019.107041
Nguyen, V. B. (2015). Effects of fiscal deficit and money M2 supply on inflation: Evidence from
selected economies of Asia. Journal of Economics, Finance and Administrative
Science, 20(38), 49–53. doi: 10.1016/j.jefas.2015.01.002
Ofori, C. F., Danquah, B. A., & Zhang, X. (2017). The Impact of Money Supply on Inflation, A
Case of Ghana. Imperial Journal of Interdisciplinary Research , 3(1), 2312–2318.
Shen, S., & Dong, X. (2019). The Structural Relationship between Chinese Money Supply and
Inflation Based on VAR Model. Applied Mathematics, 10(07), 578–587. doi:
10.4236/am.2019.107041
Zhang, S. (2018). An Empirical Analysis of the Relationship Between Money Supply and
Inflation. Management and Engineering, 32(05), 1838-5745. doi:
10.5503/j.me.2018.32.005

13. 13
Yanliang, W. (2012). Relationship Research on Money Supply, Economic Growth and
Inflation. Journal of Convergence Information Technology, 7(11), 20–28. doi:
10.4156/jcit.vol7.issue11.3