Money and Output: Correlation or Causality? - Economic Review, Third Quarter 1992 - FRB Dallas

At the center of monetary economics is a puzzling observation: innovations (unexpected surges) in the nation's total supply of money are historically correlated with innovations in real output Standard monetary economics can easily explain why an increase in the number of dollars will increase the prices of goods and thus nominal output, the dollar value of the economy's production. But why should the numher of nearly fictitious items called dollars be linked to the amount of real goods produced by workers and machines? Can dollars make workers more intelligent or reduce the breakdown of machinery? The question is of interest to policymakers as well as academics The Federal Reserve System has a great deal of control over the money supply of the United States. If changes in the money supply truly cause changes in real output, the Fed can stimulate (or hold hack) the n:.ttion's real production by manipulating the money supply. A moderation of the husiness cycle might then he within the powers of the Federal Reserve. If, instead, changes in the money supply have no effect on real output, then effDltS to stimulate the economy through money supply increases will result only in inflation. That changes in the money supply cause the changes in real output is only one way to interpret the ohserved correlation hetween the two. It might also he that the output changes cause the money supply to change or that hoth the money supply and output are reacting to innovations in some third factor. This last possihility is the focus of this article. Friedman and Schwartz in their historical studies (} 963a and 1963h) hrought the positive correlation hetween the money supply and real