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With inflation on the rise we look at an economic theory that used in order to predict future inflation movements. M3 aka money supply in the economy is often said to be a leading indicator of inflation trends. Theory goes, as money in circulation increases, consumers have more to spend, retailers know this and push up prices accordingly to absorb the excess of money supply in the market.
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M3 money supply year on year percentage change vs Inflation (CPI) year on year percentage change:
Reference is often made in economics to transmission mechanism. This refers to the time it takes from policy or changes in one economic variable to affect another. In order to show this time lag for changes to filter through to variables, data is often lagged. In the case of the M3 money supply vs CPI we will lag the CPI by 6months. Essentially we saying it takes 6 months for changes in M3 to start affecting CPI. The graph below shows the lagged data. Thus for Jan 2014 M3 money supply data, we are showing June 2014 CPI data.
M3 money supply year on year percentage change vs Inflation (CPI) year on year percentage change (6months lagged)
As can be seen from the above graph, the trends between the lagged CPI and M3 money supply is a lot more similar than the first graph where CPI was not lagged. However M3 is one of many variables that influences the inflation rate. We will cover some of the other influences on inflation in some of our upcoming blogs.