Academic journal article IUP Journal of Applied Economics

A Relook at the Short-Run Causality between Real GDP and Money Supply in India since the 1950s

Academic journal article IUP Journal of Applied Economics

A Relook at the Short-Run Causality between Real GDP and Money Supply in India since the 1950s

Article excerpt

Introduction

The causality between output and money has long been a popular area of research in macroeconomics. Researchers in this field have tried to explain the precise cause and nature of the 'money supply-real output' interlinkage. Specifically, macroeconomists have debated predominantly on the relative effectiveness of monetary vis-a-vis fiscal policy in influencing economic growth. Although there is an ever growing number of theoretical and empirical contributions in this area, economists have hardly reached a consensus on the capability of money supply to influence and promote real income and growth. The monetarists and the Keynesians have maintained polar opposite stands in this regard. The monetarists argue that a change in money supply leads to a change in nominal income and prices through the demand channel. That is, changes in nominal Gross Domestic Product (GDP) and prices are primarily caused by the changes in money supply. Hence, in their view, the direction of causation runs from money supply to nominal income and prices. The Keynesians, in contrast, maintain that money supply does not determine nominal income and prices. Rather, changes in income lead to changes in stock of money via money demand implying 'income to money' causation. According to Keynesians, changes in the price level are essentially caused by structural factors.

According to the advocates of quantity theory of money, the supply of money is exogenous. However the idea that money supply may have both endogenous and exogenous properties was proposed by Cagan (1965). He argued that increase in money supply, influences output in the short run. In the long run, it affects the price level only.

A massive upsurge in econometric studies on the causal relationship between money supply and aggregate income (GDP or GNP) began with Sims (1972) following his celebrated paper where he devised an econometric technique to examine causality between money supply and aggregate national income and tested it for the US data. His study showed evidence of unidirectional causality from money to income for the US economy. This was the first ever robust econometric verification of the monetarist claim that money causes aggregate income. Over the past couple of decades, there has been substantial empirical work on the interlinkages between money, prices and aggregate real economic activity in developed economies. Unfortunately, econometric studies on money-income and money-price causality in developing nations, especially in South and West Asian nations, are still in its early stages of development and only a few influential works are available in the literature. Studies by Sharma (1984), Singh (1989), and Verma and Kumar (1994) are prominent among the few studies conducted on India. Similar studies on Bangladesh were conducted by Jones and Sattar (1988), Parikh and Starmer (1988), and Chowdhury et al. (1995). Among the few studies conducted on Pakistan are Jones and Khilji (1988) and Masih and Masih (1997). Sadeghi and Alavi (2011) conducted a similar study for Iran using the Vector Error Correction Model (VECM) approach.

Among the pioneering Indian studies, Ramachandra (1983 and 1986) found that money causes real income and price level, price level causes real income, and nominal income causes money. Sharma (1984) explored the causality between price level and money supply adopting Granger (1969) and Sims (1972) techniques for the period 1962-1980 and established bidirectional causality between M1 and the price level and also between M2 and the price level. Based on quarterly data over the period 1960-61 to 1981-82, Nachane and Nadkarni (1985) found unidirectional causality from money supply to price level. But the causality between real income and money stock remained inconclusive. Das (2003) studied the interlinkage between money, price and output in India and concluded that there exists bidirectional causality between money and prices and unidirectional causality between money and output, with causality running from money to output. …

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