Impact of Money Supply Essays

Impact of Money Supply Essays Impact of Money Supply Essay Impact of Money Supply Essay European Journal of Scientific Research ISSN 1450-216X Vol. 41 No. 2 (2010), pp. 314-322  © EuroJournals Publishing, Inc. 2010 eurojournals. com/ejsr. htm Impact of Money Supply on Current Account: Extent of Pakistan Sulaiman D. Mohammad Department of Economics, Federal Urdu University, Karachi E-mail: [emailprotected] om Abstract The purpose of this research is to find out the empirical association among money supply, current account, exchange rate, and industrial production, for this purpose we have used (Johansen, 1988) co integration technique to analyze the long run relationship and Error Correction model to estimate the short run dynamics by using annual data for the period of 1975 to 2008. The domestic variables support long run relationship and weak relation in short run. Fragile combination of fiscal and monetary policy, finding supports Jcurve theory and expenditures switching affect theory. Keywords: Money supply, Current Account, Co-integration JEL Classification: C5, E5, F4 1. Introduction Economic management, stabilization and adjustment of any developing country are totally concern with the main instruments of an economy, monetary policy and foreign exchange rate. In most of developing economies real exchange rate shows the international competitiveness and high inflation as a result of currency devaluation and expansionary monetary policy. Monetary policy refers to implementations of central bank or monetary authorities that focusing on supply and availability of money regarding to reduce unemployment and control inflation. Keynesian economists argue expansionary monetary policy lead to economic growth, Monetarists explain ideal condition for maintaining inflation and steady growth is constant or slow increase of money supply. There are many types of monetary policies which focus on inflation, exchange rate and money supply. Monetarists believe in money supply targeting policy. In exchange rate targeting policy authorities adopt pegged exchange rate and some time devalue local currency in case of developing countries, exchange rate targeting policies lead to increase black economy. In inflation targeting or price level targeting policies central bank adjust interest rate according to economic condition. Interest rate plays a key role towards maintaining output gap and inflation (John B. Tylor). Some European and Asian countries, as well as Pakistan is also practicing inflation targeting policies. In case of our country both policies inflation targeting and exchange rate targeting polices simultaneously practiced but these policies did not show significant impact. What were the main reasons, economists argued that there is no coordination between fiscal and monetary policies. The statistical facts of money supply for last few decades mentioned in appendix. A wide ranging empirical literature has documented deferred and constant effects of monetary policy shocks on output. Theoretically real interest rate, inflation and the industrial production are the Impact of Money Supply on Current Account: Extent of Pakistan 315 result of money supply, expansionary policy leads to depreciate currency and current account deficit in short run while, contractionary monetary shock leads to current account surplus in short run (Jaewoo Lee). Many economists have examined that fluctuation in the central fund rates are a significant proxy for changes in monetary policy. Central fund rate have significant impact on macroeconomic aggregates but after 1980 it has been seen good measure of monetary policy but its impact on macroeconomic aggregates are not considerable (Nathan S. Balke Kenneth M. Emery). (Michael B. Devereux and Hans Genberg) examined by using open macro economic model in the case of China, expansionary monetary policy leads to increase in the real output and permanent price level for the time being, some countries have been selected like Hong Kong and Philippines. It is found an international imbalance have high significant correlation with China exchange rate appreciation. This study shows the positive domestic effect on international economies. Moreover, results emphasize the rising significance of China for its adjacent economies (Tomasz J. Kozluk Aaron N. Mehrotra ). (Lu Min) analyzed a two sectors in a small open economy. Applying general equilibrium approach of expectation they examined current account sensitivity to monetary policy shocks depend on the elasticity of substitution among investment, consumption and risk aversion and in case of a small open economy, current account efficiently react to technological shocks. In case of France, Italy, UK, the monetary policy shocks impact on balance of trade as a result with Expenditure-switching effect and also found a little support J-curve effect (Soyoung Kim). Money supply can be defined in Pakistan that the financial assets are highly liquid among other variables. M2 money supply variable is usually considered as proxy of money supply in most of the cases and it has a closed substitution of liquid asset as well as show the financial assets have used as medium of exchange ( Mahmood-ul-Hasan Khan Fida Hussain). J-curve theory explains the sensitivity of trade variables import and export due to devaluation or depreciation of currency. t first the depreciation in currency leads to deficit in current account and expansive import, but later on access in international market having ease competing with foreign producers cause reduce cost after some period, consequently the volume of export and price of imports increased cause to reduce the current account deficit. Inverted J-curve shows currency again get back to the appreciation. This research shows that the empirical evidence of money supply on current account variables such as import, export, net factor payment and real interest rate, exchange rate, inflation and industrial production. Impact of money supply on economy is sizzling issue of existing scenario, some fruit full detail of money supply in Pakistan find in appendix of this article. Section 1 provide introduction and literature review section 2 an 3 shows data source methodology section 4 and 5 provide result of study and recommendations. 2. Data Source Model Specification We have used time series data from 1975 to 2008. Data has taken from State bank of Pakistan’s web site, World bank data site (WDI) and International finance statistic (IFS) site. Given variables defined as; R denotes short term real interest rate, M denotes monetary aggregate M2, CPI denotes consumer price index, IP denotes industrial production, XR denotes real exchange rate NFP denotes the net factor payment, EX denotes Export and IM denotes proxy of Import. The model of our study is M= ? 0+ ? 1EX + ? 2IM + ? 3R+ ? 4CPI+ ? 5IP+ ? 6XR+ ? 7NFP+â‚ ¬ 3. Econometrics Methodology In multivariate model case, Johansen co integration technique is used to find association between the variables. This study consists six variables therefore, Engle Granger technique is not applicable because it is used for bivariate model. 16 Sulaiman D. Mohammad Generally, empirically evidences confirm that numbers of the macro variables are nonstationary series with traditional approach of ordinary least square (OLS) give the possibility of spurious regression. The non stationary in the variable can be removed by differencing the time series variable. Further objects the similar on the position that such a method involves failure of potential long run information of the data. In this situation, co integration and Error correction techniques hold long run information has been recommended. Co integration method deals with spurious regression and Error correction reflects short run dynamics and attempts to positive causal association. A series that is stationary are differencing â€Å"d† and denoted as I (d). Augmented Dickey Fuller Test also identified as unit root test are employed for testing the stationary and non stationary of the series. ADF testing the subsequent regression equation: ? Yt Y + t + ? ? 2 ? Yt ? k + ? t = ? + ? t ? 1 Where Yt stands for a time series, ? stands for a first difference, T stands for a linear trend, ? stands for a constant and ? is an error term. The null hypothesis of unit root is 0 = ?. If any variable is known to be non stationary it may be tested for stationarity at first difference. If any variable is found stationary at first difference then bivariate co integration test will be implied to recognize the association between variables. In this study Johansen test (1988) method is employed for co integration because of multivariate model. This co integration technique is employed to find out the number of co integration vector (Kerry Patterson). If any variable is co integrated, it reflects that there must be existence of an error correction in series which represent as: ? M = ? + ? 1 ? EX + ? ? IM + ? 3 ? R + ? 4 ? CPI + ? 5 ? IP + ? 6 ? XR + ? 7 ? NFP + ? 8 ? t ?1 + ? Where the error correction term is stationary residual form co integration equation. ECM reflects the ? 8 ? t ? 1 ? coefficient’s significance whether it is to be negative or positive which reflects the short run dynamics of the model. 4. Result Analysis Recent advancement in the field of eco nometrics refers that number of macroeconomics variables series are non-stationary. This influence described such regression is spurious and unpredictable to forecast, if the variables are not found stationary or integrated at different orders. Thus it is essential to verify stationarity of the variables of time series data prior to evaluating the long run association between variables. Table 1: Variables Import Export R CPI IP XR NFP M Significant at 5%level, Lag () Unit root test ADF (Augmented Ducky Fuller) Level with intercept and trend (lag length) 1. 90522(0) 1. 30590 (0) 2. 565322 (0) 3. 212361 (1) 3. 159647 (3) 1. 754631 (1) 2. 32541(3) 1. 95214(3) First Difference with intercept and trend (lag length) 6. 805222(1) 6. 579430 (1) 5. 422587 (0) 4. 646054 (5) 4. 366135 (5) 7. 389702 (0) 4. 23000(1) 5. 32511(1) The table-1 shows the result of unit root test found from using the Augmented Dickey Fuller (ADF) test. This test has been evaluating the stationarity in the variables with trend and intercept. After evaluated the stationarity at level, our result reflects that there is non stationarity in the data series therefore, we test out the stationarity at first difference, and hence our result exhibits that all the variables are stationary at first difference, now ADF equation is employed again with trend and Impact of Money Supply on Current Account: Extent of Pakistan 317 intercept. The brackets values exhibit the lag length of difference variables and all variables are integrated at first order i. e. is I (1). After evaluated the stationarity between the variables, result postulates that the data is integrated at second order and our next step to verify the long run association between variables whether it is exist or not, for this purpose the Johansen co integration test has been used and its findings in table-2 and table-3 as: Table2: Johensen Co integration test (trace value) Alternative Hypothesis r=1 r=2 r=3 r=4 r=5 r=6 Maximum trace statistics 240. 5128* 157. 804* 97. 22221* 57. 29995* 27. 08921 8. 609252 5% critical value 125. 6154 95. 75366 69. 81889 47. 85613 29. 79707 15. 49471 P-Value 0. 0000 0. 0000 0. 0001 0. 0051 0. 0995 0. 4028 Null Hypothesis r=0 r=1 r=2 r=3 r=4 r=5 Table 3: Johensen Co integration test (Eigen value) Alternative Hypothesis rgt;1 rgt;2 rgt;3 rgt;4 rgt;5 rgt;6 Maximum Eigne Value 83. 23238* 60. 05818* 39. 92226* 30. 21074* 18. 479 96 7. 523857 5% critical value 46. 23142 40. 07757 33. 87687 27. 58434 21. 13162 14. 26460 probability 0. 0000 0. 0001 0. 0084 0. 0225 0. 1129 0. 4292 Null Hypothesis r=0 r=1 r=2 r=3 r=4 r=5 Table no. 2 and 3 shows the result of co integration test. The Johansen- Juselius co integration test illustrates that all these seven variables are co integrated of six vector as we saw in the given table2 and table-3, both maximum trace statistics and maximum eignen values reflect r=6 co integration equation. Optimal lag of VAR model is 2-lag by using Shewariz criterion therefore, the result shows six co integration equations in the VAR model postulates the long run association between variables. The subsequent table-4 exhibits the result of Error Correction Model equation as above given. The ECM is used to analysis the spurious correlation in the short run dynamic association among output, financial structure, physical and capital formation, and financial development. The long run dynamics show in the set of regression equations. Technically, Error Correction Technique calculates the pace of adjustment get back to Co-integrated associations. The ECM estimates a force influencing the integrated variables to go back their long-run relation when they deviate from the deviation (Banerjee, et al, 1994). An equation of error correction model as: ? M = ? + ? 1 ? EX + ? 2 ? IM + ? 3 ? R + ? 4 ? CPI + ? 5 ? IP + ? 6 ? XR + ? 7 ? NFP + ? 8 ? t ? 1 + ? Table 4: Variables D(Exp) D(Imp) D(R) D(CPI) D(IP) D(XR) D(NFP) UT(-1) Error Correction Method Result T-Value -2. 2 2. 8 1. 9 2. 1 2. 3 1. 85 -2. 6 -0. 3 P-Value 0. 02 0. 06 0. 08 0. 09 0. 01 0. 08 0. 05 0. 06 318 Sulaiman D. Mohammad The estimated lagged ECM [error correction term], UT(-1) is negative and highly significant. This result supports the co integration between the variables exhibited in table-3. The feedback coefficient is –0. 3, which advocates a normal adjustment process. Almost 30% of the disequilibria of the earlier year’s shock adjust back to the long run equilibrium association in the present year. 5. Conclusion Implication This research evaluated the effects of money supply on current account using a Johnson’s co integration approach for the economy of Pakistan from the period 1975 to 2008. Our model has exhibited a number of important findings which confirm the impact of monetary policy shocks on current account is dependable on expenditure switching effect, and our results also reflect the little evidence of J-curve impact. Our co-integration and ECM findings also support the theoretical analysis. Our main finding is that the monetary policy system has an important influence on the domestic variables (for instance, output and inflation), but has less influence on external variables such as current account and real exchange rates. In policy rules we have examined that the policy rules seem to work best overall therefore, central bank should target the domestic (producer) inflation. The central bank ought to focus to manage the impact of the currency depreciation on import price inflation rather than adjusting interest rates which help to keep stable producer prices. Our finding also suggests applying pegged exchange rate system due to the high valued currencies are not only lead to volatile inflation but also slow down economic growth. References [1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] David K. Backus and Patrick J. Kehoe, â€Å"International Evidence on the Historical Properties of Business Cycles†, The American Economic Review, Vol. 82, No. 4(Sep. , 1992), pp. 64-888 Balke, Nathan S. and Kenneth M. Emery (1994), `The Federal Funds Rate as an Indicator of Monetary Policy: Evidence from the 1980s, Economic Review, Federal Reserve Bank of Dallas, First Quarter, pages 1 16. Michael B. Devereux and Hans Genberg, â€Å"Currency appreciation and Current account adjustment†, HKIMR Working Paper No. 17/2006, December 2006 Tomasz J. Kozluk Aa ron N. 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Mohammad Appendix Time Deposits M2 as % of Total Deposit GNP (1970-2007) In case of Pakistan the central bank uses these major tools of monetary pol icy: credit to commercial banks, interest rate channels , margin requirement and cash reserve ratios. Impact of Money Supply on Current Account: Extent of Pakistan 321 322 Growth Rates of Monetary Variables (%) Sulaiman D. Mohammad Where gM1: Represent the Growth Rate of Money Supply (M1) gM2: Represent the Growth Rate of Broad Money Supply (M2) gRM: Represent the Growth Rate of Reserve Money.