May 25, 2001

As we've stated many times before, inflation is too much money chasing too few goods. An excess supply of money in relation to the supply of goods leads to higher prices while excess demand results in lower prices. A simple textbook modeling of the money market and its equilibrium conditions assumes that the Fed controls the supply of money. Hence, the quantity of money (as measured by the monetary aggregates) can be used as a proxy for shifts in the money supply. To finish the model, we need a proxy for the demand for money. The most commonly used proxy for this is real GDP growth. The assumption being that, as real GDP growth increases, so does the demand for transaction balances (and the demand for money). So, according to this model, by looking at the growth of the monetary aggregates in relation to real GDP growth, one can determine whether there is an excess demand or supply money condition.

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