Monetary policy decision makers ignore and disdain the relationship between money and inflation. Based on old research done in the United States, they argue that there is no “stable” relationship over time between the amount of money and inflation. Nothing more wrong than this dogma. Therefore, forecasts and monetary policy decisions are wrong and biased.
On the other hand, for the monetary aggregate to reduce its monthly growth to just one digit, the target interest rate of the Bank of Mexico must be at least 8%-9%. This same commented a year ago in this space.
Why is there a relationship between the amount of money and inflation?
The answer is obvious, but let’s better see it with a very simplified example.
Suppose there are only two goods in an economy, apples and gasoline. Both are bought with money. Furthermore, in that economy there is a stock of money available for 100 pesos.
Suppose also that each month a new apple is produced and that the production of gasoline is constant. However, for some reason, the central bank of that country is injecting twice as much money as it would take to buy each apple that hits the market month after month.
For its part, the government tells apple entrepreneurs that they cannot raise the price of apples, despite the fact that there is more cash in the economy.
Finally, there is an external shock on the supply side of energy (gasoline) that substantially increases its price, making the distribution of apples more expensive in that country.
Since there is more money in the economy, it seems that people could offset the increase in the price of gasoline with the more cash that is circulating. However, since wages do not rise as nominal cash rises, this is impossible. People don’t have any more money.
So the government decides to intervene by subsidizing the increase in the price of gasoline. The government takes a good part of that excess cash to pay for its expenses and subsidies through borrowing. Thus, the government enters an unorthodox cycle of intervention in the money and goods markets.