Causality between money and prices evidence from Pakistan

Abstract

The relationship between money and prices has long been a debated issue between the Monetarists and the Keynesians. The monetarists claim that inflation is caused by growth in money stocks, whereas the keynesians argue that structural factors are responsible for inflation. This paper re-examines the causal relationship between money and prices in Pakistan using recent data on money and prices and taking care of time series properties. Monthly data on prices and money stocks were used from July 1981 to June 1998. Two measures of prices (CPI and WPI) and three measures of money stocks (MO, MI, and M2) were taken and cointegration and error correction models were employed. The analysis involve three steps. At the first step, the Unit Root Tests indicate that all the money and price variables are integrated of order one. Next, the Cointegration analysis suggest that three exist a long run relationship between prices and M2 definition of money. The other definitions of money do not seem to be related with prices. Finally, the Error Correction Models suggest, in general, a unidirectional causality running from money to prices. This supports the monetarist's claim regarding the role of money. The results further suggest that the monetary expansion has a greater impact on wholesale sale prices compared to Consumer Prices.