It may be the case that while a close relationship is apparent in the data when large changes in money growth are observed, no clear relationship emerges when the changes are relatively modest, such as in the United States. In those cases, other inflationary factors may dominate the effect of relatively small changes in money growth. The findings depend greatly on the monetary aggregate used to measure money growth. However, results using narrower definitions of money, namely M1 and the monetary base, show no clear relationship over any of these time horizons. Before discussing the results of the analysis, it will be helpful to have in mind a simple textbook theory that is widely thought to explain the basic relationship between the money supply and prices.
Inflation occurs when the average level of prices increases.
Individual price increases in and of themselves do not equal inflation, but an overall pattern of price increases does. The price level observed in the economy is that which leads the quantity of money supplied to equal the quantity of money demanded. The quantity of money supplied is largely controlled by the Federal Reserve. When the supply of money increases or decreases, the price level must adjust to equate the quantity of money demanded throughout the economy with the quantity of money supplied. Money demand is widely thought to increase roughly proportionally with the price level and with real income.