MONEY AND INFLATION N CHINA 671 error correction model(ECm) to identify short-run and long-run interdependen cies and the causal linkage between prices and money stock. This approach avoids the spurious regression problem and offers a parsimonious time series approach based on a more general inflation model with a rich dynamic structure Third, it is a well known fact that the official price indices in China do not provide a proper yardstick for measuring the overall extent and character of inflation due to inflationary repression over a long period of time. Previous studies concerning the money-price relationship have focused on the official price indices(Chow, 1987; Huang, 1995). In contrast, we use a measure of the true price index to explore an otherwise hidden relationship between money and prices. Despite the institutional differences between the Chinese economy and other Western market economies, the statistical techniques, when supplemented with the true price index, unravel the monetary dynamics of the inflationary process in China The paper is organized as follows. Section 2 presents a more general model designed to estimate the monetary dynamics of inflation and discuss the institu- tional issues in China that affect the application of the monetarists'modeling strategy. Sections 3 and 4 present the estimates, while the final section offers a 2. THE MODEL We start with a simple and transparent quantity theory model to explain the monetary dynamics of inflation in China. Irving Fishers(1911)celebrated quantity equation of exchange was responsible for assigning monetary forces the principal role in the determination of the price level where M,v, P, and y are the quantity of money, the income velocity, the price level, and real income, respectively. Classical, monetarist, and new classical economists invoke several assumptions to convert this simple identity to rticulated theory. The classical assumptions of full employment equilibrium fully flexible price and wages, Friedman's statement of the natural rate of unemployment, and the rational expectation hypothesis of the New Classical economists characterize a time path where long-run monetary growth only determines the rate of inflation. If we interpret the quantity theory as a long-run equilibrium and supplement it with a short-run error correction mechanism obtain a dynamic path of the inflation rate that cannot deviate too far from the path of long-run solution values. More specifically, combining the notion of tegration and the error correction mechanism, we specify the following del to capture the dynamic essence of the inflation rateerror correction model (ECM) to identify short-run and long-run interdependen￾cies and the causal linkage between prices and money stock. This approach avoids the spurious regression problem and offers a parsimonious time series approach based on a more general inflation model with a rich dynamic structure. Third, it is a well known fact that the official price indices in China do not provide a proper yardstick for measuring the overall extent and character of inflation due to inflationary repression over a long period of time. Previous studies concerning the money–price relationship have focused on the official price indices (Chow, 1987; Huang, 1995). In contrast, we use a measure of the true price index to explore an otherwise hidden relationship between money and prices. Despite the institutional differences between the Chinese economy and other Western market economies, the statistical techniques, when supplemented with the true price index, unravel the monetary dynamics of the inflationary process in China. The paper is organized as follows. Section 2 presents a more general model designed to estimate the monetary dynamics of inflation and discuss the institu￾tional issues in China that affect the application of the monetarists’ modeling strategy. Sections 3 and 4 present the estimates, while the final section offers a summary and conclusion. 2. THE MODEL We start with a simple and transparent quantity theory model to explain the monetary dynamics of inflation in China. Irving Fisher’s (1911) celebrated quantity equation of exchange was responsible for assigning monetary forces the principal role in the determination of the price level, MV 5 PY, (1) where M, V, P, and Y are the quantity of money, the income velocity, the price level, and real income, respectively. Classical, monetarist, and new classical economists invoke several assumptions to convert this simple identity to an articulated theory. The classical assumptions of full employment equilibrium, fully flexible price and wages, Friedman’s statement of the natural rate of unemployment, and the rational expectation hypothesis of the New Classical economists characterize a time path where long-run monetary growth only determines the rate of inflation. If we interpret the quantity theory as a long-run equilibrium and supplement it with a short-run error correction mechanism, we obtain a dynamic path of the inflation rate that cannot deviate too far from the path of long-run solution values. More specifically, combining the notion of cointegration and the error correction mechanism, we specify the following model to capture the dynamic essence of the inflation rate, MONEY AND INFLATION IN CHINA 671