Academic journal article Journal of Financial Management & Analysis

Evidence from the European Union on Testing the Kumara Swamy Theorem of Inflationary Gap

Academic journal article Journal of Financial Management & Analysis

Evidence from the European Union on Testing the Kumara Swamy Theorem of Inflationary Gap

Article excerpt

Introduction

On March 3, 1978, Professor M.R. Kumara Swamy proposed the unique and well thought out Kumara Swamy Theorem of Inflationary Gap during the convocation lecture on 'Inflation and Economic Development of Nigeria' at the Institute of Management and Technology, Enugu, Nigeria (Swamy1):

The growth of the money supply in a country must be twice the growth of real output to maintain price stability. Thus the difference between money supply and real output is the actual inflationary gap, while the permissible inflationary gap is the difference between real output and double (permissible) money supply. The excess of the actual gap over the permissible gap is referred to as the excess inflationary gap caused by noneconomic development factors like maintenance of unproductive enterprises (non-performing assets) and we may add corruption and fraud premiums.

This theorem has been examined in several studies that concentrated on testing in Canada, Cyprus, Greece, Mexico, Nigeria and the U.S.A as documented in Swamy'2, Lazaridis and Livanis3, Bauer and Faseruk4 and Faseruk, Bauer and Glew5.

Professor Swamy provided the seminal testing for this theorem that related money supply growth to economic output on the Nigerian economy in "A Financial Management Analysis of Nigerian Economic Situation: Problems and Solutions" in the Nigerian Journal of Financial Management2 and "Empirical Testing of the Kumara Swamy Theorem of Inflation Gap: Nigerian Economy in Perspective" in the Journal of Financial Management and Analysis'. Lazaridis and Livanis3 tested the theorem outside the developing world in Greece and Cyprus, while Bauer and Faseruk" examined Canada, and Faseruk, Bauer and Glew5 extended testing to all nations within the North American Free Trade Agreement.

Faseruk, Roubi and Barth6 along with Swamy1 have contended that high levels of inflation became endemic to the markets in the late 1960s and persisted through the 1970s into the early 1980s. Its effects are still being felt today. The persistence of inflation can be exacerbated by policy makers who enact policies designed to control core inflation without adequate knowledge of the permissible inflationary gap and the excess inflationary gap as argued in Swamy. Accordingly, it is important for a model to both explain the nature of these inflationary gaps. The growth in the money supply needs to outpace the growth of real GNP to maintain price stability. The size of the inflationary gap is determined by establishing a synchronized correlation between the growth of real GNP (GNI) and the money supply. These antecedent conditions were cogently articulated into a concise testable model referred to as the Kumara Swamy Theorem of Inflation Gap which states:

The growth of money supply of a country must be twice the growth of real GNP to maintain price stability, and the rational size of inflationary gap is determined by establishing a synchronized correlation between the growth of real GNP and money supply'. The purpose of this study is to test and comment on the Kumara Swamy Theorem of Inflationary Gap in the countries of the European Union over the period January 1,1999 to December 31,2011.

Prelude

Europe provides several diverse economies on which to test the Kumara Swamy Theorem, as this large area contains both a trading union and, for the most part, a common currency. The European Union (EU) began to form following the Second World War with the Treaty of Paris that established the European Coal and Steel Community in 1952. The founding nations were Belgium, France, Federal Republic of Germany (West Germany), Italy, Luxembourg, and the Netherlands. In 1957, the Treaty of Rome superseded the Treaty of Paris in establishing the European Economic Community (EEC) and the European Atomic Energy Community (EURATOM). Through successive enlargements of the community, (such as the joining of the EEC by Denmark, Ireland and the U.K. in 1973, and the Maastricht Treaty of 1993, which formally established the European Union), the trading area has increased to currently encompass 27 countries. …

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