Friday, February 12, 2016

What is the relation between GDP growth and base money growth?

A few days back I showed this graph:

Graph #1: Growth Rate of the Monetary Base
Shows two unusually long periods of slowing money growth. The extended slowing was followed in one case by the Great Depression, and in the other by the Great Recession.

Each time, after the crisis hit, there was a period of exceptionally rapid money growth, as if policymakers understood that slow money growth had caused the problem, and that rapid money growth was the cure.

I think Graph #1 shows something extremely important.

In comments on the graph, Oilfield Trash said

I do not understand how one can simply look at change in stock and determine that is bad for GDP, with out looking at the velocity of the monetary stock ...

Good point. There certainly seems to be some relation between an extended period of slowing money growth and economic calamity. But I'm not prepared to say what that relation is. So Oilfield's observation is useful.

What is the relation between GDP growth and base money growth?

Graph #2: Growth Rates of Base Money (blue) and Real GDP, 1990-2008
Base money (blue) shows persistently falling growth from September 2001 to the crisis.

The growth of real output increases from 2001 to 2004, then turns downward and runs parallel to base money growth. As if the decline in money caused the decline in economic growth.

That shouldn't be surprising; it's how monetary policy is supposed to work.

I took the same two data series, base money and inflation-adjusted GDP, and looked at the RGDP-to-Base ratio to get an additional perspective on the relation between the two series. This one runs from 1947 to 2015:

Graph #3: RGDP Relative to Base Money, 1947-2015
Oh! I love it when a graph shows very few distinct trends. Increase, from 1947 to 1966. Decrease then, quite rapid till about 1994, slower thereafter, and becoming very flat for several years before the crisis. Those particularly flat years are 2004 to 2008, same as in the red circled area on Graph #2.

The line runs suddenly downward, near vertical, late in 2008, and continues to drift downward since.

Before 1966, Real GDP grew faster than base money. In other words, it was not loose money in the early 1960s that created the Great Inflation of 1965-1984.

Since 1966, Real GDP grew more slowly than base money -- both during and after the Great Inflation. There is no particular disturbance visible on the graph that would suggest Paul Volcker quashed inflation by manipulating the money. Unless... unless there was a link between RGDP and base money that caused them to move in sync.

The flat spot of 2004-2008 is flat and low. It gives the appearance -- indeed, the whole downtrend since 1966 gives the appearance of resistance to the downward movement. The line flattens over time. Until 2008, of course, when the economy suffered major damage, from which it has not yet recovered.

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