Correlation between M1 and GDP Explained

Correlation between M1 and GDP Explained

The trend in Figure 1 shows that the money supply increases as the GDP increases. However, correlation shows the directional movement of data, either positive or negative, but does not indicate the causality of variables. For example, the increase in money supply does not cause a resultant increase in the GDP– the status of the economy remains the same if the intrinsic factors with which it depends do not change. Besides, for the graph in Figure 1 to show causality, then M1 should be a factor of GDP, where regression analysis would help determine the positive or negative effect of M1 on GDP. Therefore, Figure 1 indicates the neutrality of money because it does not show the correlation between the two data sets. 

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Further, the observation in Figure 1 is that GDP has always been higher than the money supply since 1959. Higher GDP compared to money supply indicates that the elements of GDP always remain higher than the factors that affect M1. For instance, the level of consumption, which is a measure of GDP, should be higher than the prevailing interest rates. Also, the notion that the neutrality of money settles in the long term is in Figure 1, where the difference between the GDP and M1 widens as time proceeds­, such that the two graphs began in the same position and diverged outward. Therefore, the neutrality of money is for the nominal variable that does not affect the real GDP. 


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