During the Great Inflation of the 1970s, (a) the growth rates of M1 an

During the Great Inflation of the 1970s, (a) the growth rates of M1 and M2 were higher than previously, and (b) the growth rate of M2 was much higher than the growth rate of M1.

Explain how the high inflation of the decade relates to each of these facts.

ANSWER

By the quantity theory of money, rapid growth of the money supply (relative to the growth rate of aggregate output) causes the inflation rate to be high. When inflation is high, holding cash and non-interest bearing deposits is costly, so people shift as much money as possible into interest-bearing accounts, so the narrow monetary aggregate M1 does not grow as fast as the broader aggregate M2. By the Fisher effect, nominal interest rates rise with expected inflation, so interest-bearing accounts provide some compensation for inflation.