- The money supply is not controlled in anyways by the central bank. Not only does the money multiplier theory not apply, but also the growth of the money supply is driven primarily by the demand for bank credit by private economic units (banks cannot force feed credit to economic units) and by government spending and taxing.
- Interest-rate targeting has only a remote and uncertain effect on the growth of the money supply, even more so on inflation.
- The economy is rarely at full employment so if the demand for goods and services increases the supply of goods and services increases.
- Measuring the natural growth rate of the economy is actually difficult. More importantly, the demand for goods and services and supply of goods and services are not independent factors. Demand matters even in the “long run.” Greenspan put it nicely during an FOMC meeting:
“Let me just say very simply – this is really a repetition of what I’ve been saying in the past – that we have all been brought up to a greater or lesser extent on the presumption that the supply side is a very stable force. […] In my judgment our models fail to account appropriately for the interaction between the supply side and the demand side largely because historically it has not been necessary for them to do so.” (Greenspan, FOMC meeting, October 1999, pages 46–47)
- In terms of basic empirical evidence, the strong correlation between money supply and price that one should expect does not exist even in the long-run (Figures 1 and 2). While correlation improves as the length of time increases (one-year correlation is 0.55, five-year correlation is 0.67, ten-year correlation is 0.71), the correlation is weaker than what the theory suggests.
- The fact that inflation and money supply growth are positively correlated does not tell us the direction of causality. One may doubt that the causality goes from M to P given the strong assumptions required for that to be the case. The next section will develop this point.
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