The causality relationship between money supply, inflation and Real GDP

Table of Content

Abstract

1. Introduction
1.1. Back ground of the study
1.2. Statement of the Problem
1.3. Objective of the study
1.4. Scope of the study
1.5. Organization of the paper

2. Literature Review
2.1.Theoretical Literature Review
2.2. Empirical Literature Review
3. Research methodology
3. 1. Source and type data
3.2. Method of data analysis
3.3. Model specification

4. Empirical Result and discussion
4.1. Tests for Stationary, Unit root test (ADF)
4.2. VAR lag order selection criteria
4.3 .VAR Granger causality result
4.4. Wald test result results

5. Policy Implication and Recommendation

Reference

The causality relationship between money supply, inflation and Real GDP: case study in Ethiopia

Moges Endalamaw Yigermal

Abstract

Since the main objective of the paper is to test the existence of causality relationship between the three macroeconomic variables, namely real GDP, price level (CPI) and M2 money supply (MS), analysis has been made there by employing 40 years of data (data from 1975-2014). VAR Granger causality test has been made to verify the objective of the paper.

The VAR Granger causality test result suggesting the existence of strong and significant correlation between the three variable s pairwise. The direction of causation is found to be a uni- directional causation between money supply and inflation, real GDP and Money supply and between real GDP and inflation and the causation runs from money supply to inflation, real GDP to Money supply and real GDP to inflation respectively. From the causation we observed that money supply has relationship with level of price and economic growth (real GDP). Basically targeting monetary expansion has a multiple role to boost economic growth and control the level of inflation.

Keywords:VAR Granger causality, macroeconomic variables, money supply

Inflation and real GDP

1. Introduction

1.1. Back ground of the study

Keynesians, monetarists, and new classical economists agree that the steady state rate of inflation is closely related to growth of the money supply, and that monetary policy can not affect the equilibrium rate of unemployment.

The best slogan of monetarist school of thought “money matters”, they argued that changes in the amount of money in the circulation are the sources of other economic changes. In other words, the changes in the size of money supply have a number of implications on the macroeconomics variables especially inflation. Apart from being a powerful instrument of monetary policy, its expansion or contraction dictates the growth in investment and output of any economy. The supply of money is widely accepted as a key determinant of the levels of output and employment in the short run and the level of prices in the long run.

Reference ^[1] found that the change in inflation correlated, positively with the growth in money supply and negatively with respect to growth in real income or output ceteris paribus. In support of this argument, ^[2] found that the period of oil boom in Nigeria characterized by rapid monetary growth was consistent with the periods when the country experienced double-digit inflation.

Monetary policy targets of a countries central bank may depends on a number of factors that are unique and contextual to the country’s economy. According to ^[2], money supply, credit, interest rates and expenditure may be such targets. However, in the case of Ethiopia a, as is evident from the national bank of Ethiopia’s Monetary Policy Framework, money supply or money stock has been the intermediate target of monetary policy of Ethiopia.

1.2. Statement of the Problem

There is no doubt that the persistent rise in the price levels of commodities and services adversely affects the economic performance of a country. Hence, the economic goal of every government is to maintain low and relatively stable levels of inflation, Stress must be made to control the level of money supply in line with the level of output which is appropriate for the given economy to achieve the macroeconomic stability objective of central banks of a nation. In Ethiopia also the current target of monetary policy of NBE is to ensure that the money supply growth is in line with nominal GDP growth rate.

Empirical Evidence from Sudan (2011) on Long–Run Relationship between Money Supply, Real GDP, and Price was found to be uni-directional causation from real GDP to CPI and from money supply to price level. the co-integration analysis also shows that the real GDP, money supply and CPI were found to be co-integrated and it suggesting the existence of long-run relationship among these three macro-economic variables.

A study by ^[3], Inflation survey in four selected east African countries (Ethiopia, Kenya, Tanzania and Uganda) presented that the growth in money supply plays significant role for the increment in inflation and accounts for 40 percent of the inflation growth rate in Ethiopia. This indicates that controlling the level of money supply in line with the income level is vital to control inflation and boost economic growth.

To this end the focuses of this paper is to determine the causality relationship between the three macroeconomic variables (money supply, CPI and Real GDP) to Ethiopian economy and to explore, whether there exists long-run relationship among these variables or not.

1.3. Objective of the study

The general objective of the paper is to examine the causality relationship between three macroeconomic variables (real Gross Domestic Product (RGDP), money supply (M2) and price level (CPI)) for the Ethiopian economy. Specifically the paper try to address the following objectives:-

- To check the direction of causation between real Gross Domestic Product and inflation
- To evaluate direction of causation between money supply and inflation
- To look at direction of causation between real Gross Domestic Product and money supply

1.4. Scope of the study

The scope of the study is bounded to the extent of causal relation between the three macro-economic variables for Ethiopian economy. The study also tries to address direction of causation between Real GDP, CPI, and M2 for Ethiopian economy.

1.5. Organization of the paper

The paper organized under five chapters. The first chapter deals with the introduction part which contains introduction, statement of the problem, objective, working hypothesis, scope of the study. The second chapter includes both theoretical and empirical reviews. The third chapter will cover methodologies and model specification of the study. The fourth chapter will about analysis of data. The final chapter, which is Chapter five, was designed to provide conclusion and policy recommendation based on the study obtained from analysis.

2. Literature Review

2.1Theoretical Literature Review

The Monetarists claim that money plays an active role and leads to changes in income and prices. They suggest unidirectional causation runs from money to income and prices without any feedback, In other words; they conclude that changes in income and prices in an economy are mainly caused by the changes in money stocks.

The Keynesians, on the other hand, argue that money does not play an active role in changing income and prices. Rather they argue that, changes in income cause changes in money stocks via demand for money implying that the direction of causation runs from income to money and they suggest that changes in prices are not mainly because of the change in money supply rather structural factors accounts for the change in price level or inflation.

Theories developed by Economists explaining the interaction between money supply, the level of output produced and the inflation rate in the economy. The classical economists insist that in the short-run the increase in money supply can stimulate both increase in money supply and increase in output. In the long-run output must return to the natural level so that the effect of increase in output is increase in prices ^[4].

The Keynesian economists hold that the effect of increase in money supply is dependent on whether the economy is operating below full employment or not. If the economy is operating below its equilibrium output, an increase in money supply can increase output. But once full employment is attained increase in money supply will lead to one on one increase in the general price level ^[5].

2.1.1. Money supply, inflation and economic growth in Ethiopia

At the end of 2013/14 broad money supply in Ethiopia (M2), reached Birr 297.7 billion reflecting a 26.5percent annual growth mainly due to a 28.4 percent surge in domestic credit accompanied by 0.9 percent Slight growth in external assets (net). The significant expansion of domestic credit was attributed to a 29.2 percent increase in credit to the non-central government and 21.2 percent growth in credit to central government ^[6].

Annual average national head line inflation at the End of fiscal year 2013/14 was 8.1 percent, about 5.4 percentage points lower than last year. This was due to the slowdown in both food & nonalcoholic beverages and non-food inflation by 6.7and 3.9 percentage points, respectively. As usual, food & non-alcoholic beverage inflation contributed the lion’s share to the5.4 percentage point slowdown in annualized headline inflation ^[6].

As far the Economic Growth of Ethiopian economy is concerned it continued to register remarkable growth, and the Real GDP expanded by10.3 percent in 2013/14, which was beyond the GTP1^[1]target of the country’s economic growth rate which was 11.2 Percent for 2013/14. This economic growth has also been impressive compared with the 5.4 Percent growth estimated for Sub-Saharan Africain2014 ^[6].

2.2. Empirical Literature Review

There is no doubt that, Money supply, national income, and prices are considered as a three major macroeconomic variables that play an essential role in determining the rate of economic growth. A number of studies showed the causal relationship between money supply and income (GDP). Some studies showed unidirectional causality either from money supply to price level (CPI) or from price level (CPI) to money supply, while others are bi-direction causal. Some did not find any evidence of causal relationship.

Reference ^[6] conduct a study on the long-run relationships between three macroeconomic variables (real Gross Domestic Product (GDP), money supply (MS) and price level (CPI)) have been examined for the Sudan economy using annual data over the period 1960 to 2005. They employed Granger Causality to explore the short-run direction of causality between GDP, MS and CPI, and co-integration analysis for long run relationship. And finally their empirical result shows that there exists causation between real GDP and prices and the magnitude was found to be unidirectional from real GDP to CPI. And also the co-integration analysis established that the real GDP, money supply and CPI were found to be co-integrated suggesting a existence of long-run relationship.

Reference ^[7] tested the causality between money, price, and output in India. They found bidirectional causality between money supply and output, and a unidirectional causality from price level to money supply and output.

A study by ^[8] attempts an investigation of the causal relationship between money and income and between money and prices in Pakistan. They revealed evidence of a unidirectional causality from income to money and from money to prices. (ibid)

Reference ^[7] used annual Time series data for the period 1976-2009. The results indicate that there is not an existing short-term relationship between money supply (M1) and GDP growth in Jordan. While they found out that there is a causal relationship from money supply to inflation.

Reference ^[9] investigates the interaction between money supply, inflation and output in Nigeria using time-series data of 1970 – 2009. The study uses time series methods of unit root test, co-integration test and vector error correction (VEC) model. The results shows that aggregate money supply significantly stimulate the level of aggregate output. It has also demonstrated that there is only one level of interaction from money supply to output and not from output to money supply. The ECM showing that there is short-term deviation from long-run equilibrium relation which takes roughly two and a half months to correct through reduction in output.

On the other hand ^[10] found unidirectional causality from income to money and bidirectional between money and prices in Pakistan found unidirectional causality from income to money and bidirectional between money and prices in Pakistan.

The other study by ^[11] examined the impact of inflation on economic growth in Tanzania economy and established the existence of inflation growth relationship. Time-series data for the period 1990 -2011 were used and Correlation coefficient and co-integration technique established the relationship between inflation and GDP and Coefficient of elasticity were applied to measure the degree of responsiveness of change in GDP to changes in general price levels. Results suggest that inflation has a negative impact on economic growth. The study also revealed that there was no co-integration between inflation and economic growth during the period of study. No long-run relationship between inflation and economic growth in Tanzania.

Reference ^[11] investigates the causal links between inflation, budget deficit and money supply in Ethiopia using time-series data of 1964 – 2003. The study uses modified version of Granger causality and the dynamic least squares (DOLS) and the fully modified ordinary least squares (FMOLS). The study demonstrated that long-run relationship exists among money supply, inflation, budget deficit and inflation.

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^[1]Growth and Transformation Plan of Ethiopia (GTP) 2010/11-2014/15

^[1] Bakare AS (2011). An empirical study of the determinants of money supply growth and its effects on inflation rate in Nigeria

^[2] Beecham, B.J.(1986).The Monetary and Financial System. First Edition, London

^[3] African Development Bank (2011), Inflation Dynamics in selected East African countries: Ethiopia, Kenya,Tanzania and Uganda.

^[4] R. Dan and Wanjuu (2010), Interaction among Money Supply, Inflation and Output in Nigeria: A necessity For Sustainable Economic growth.

^[5] Keynes, 1936, the General Theory of Employment, Interest and Money, ISBN 9780230004764.

^[6] Annual Report: National Bank of Ethiopia Annual Report, Fiscal year 2013-2014.

^[7] Torki M. Al-Fawwaz & Khaled Mohammed Al-Sawai’e, (2012), The Relationship Between Gross Domestic Product And Government Expenditures In Jordan: A Var Approach.

^[8] A. E.M. Ahmed, and S.Z. Suliman,(2011) The Long–Run Relationship Between Money Supply, Real GDP, and Price Empirical Evidence From Sudan Journal of Business Studies Quarterly, 2011, Vol. 2, No. 2, pp. 68-79 ISSN 2152-1034.

^[9] Husain and Rashid (2006), A shift in causal relations of money, income and price in Pakistan: the price hikes in the early 1970s.

^[10] Faraji & Kenani (2013), Impact of Inflation on Economic Growth: A Case Study of Tanzania: Asian Journal of Empirical Research, 3(4)2013: 363-380.

^[11] Wolde –Rufael (2008), the causal links between Budget Deficits, Money and Inflation: The Case of Ethiopia.