the Central Bank does not control the money supply, or due to the hypothesis that
inflation may not, in fact, be a monetary issue.
When there is an increase in the price level, there will be as a consequence the decline
of the real value of the government liabilities, understood here as the pooled liabilities
of both the Treasury and the Central Bank. These liabilities comprise therefore the stock
of government debt, in possession of the public, and the stock of monetary base. As a
result of the price level rise, there is a negative wealth effect through the reduction of
the real value of the individuals applications, for instance in government debt. Hence,
there may occur a decrease of aggregate demand, with prices adjusting aggregate
demand and supply in the short run.
For instance, with a fixed money supply, the increase of the budget deficit may be
accompanied by the rise of prices, allowing the decrease of the real value of public
debt, in order to guarantee the fulfilment of the government budget constraint.
Following the above reasoning, one may recall the weak correlation between money and
prices since the start of the 80s, in most of the industrialized countries, with the
progressive abandon of monetary aggregates as an intermediate objective of monetary
policy.4
Lets then consider the traditional relation of the quantitative theory of money, between
money and income,
Mvt = Ptyt (1)
where M is nominal money, P is the price level, y is real income and v stands for the
income-velocity of money.5 Assuming, for instance, that the income-velocity of money
depends on the nominal interest rate, vt=v(it),6
4 "Throughout the English-speaking world, at least, central bankers have abandoned the notion that
any of the conventional monetary aggregates constitute a suitable intermediate target for monetary
policy. This has resulted from the discovery that these aggregates no longer appear to have any very
reliable relationship, at least in the short run, with the variables, such as inflation and real activity,
about which policymakers actually care" (see Woodford (1998b)). The same point is made by Romer
(2000): “(...) most central banks, including the U.S. Federal Reserve, now play little attention to
monetary aggregates in conducting policy.” Dwyer and Hafer (1999) review some of the latest
evidence concerning the relationship between monetary growth and inflation.
5 Naturally, the classic reference for the identity of the quantitative theory of money is Fisher (1911,
p. 24-32).