Money, output, and inflation: Evidence from Pakistan

Abstract

It is generally accepted that the effect of money supply changes is transmitted into output and inflation, though with some lags. If this hypothesis cannot be rejected empirically, then we can say that monetary factors play an important role in determining inflation. To find out whether this has happened in Pakistan is the key objective of this study. We have tested this hypothesis empirically by applying the Near- VAR approach to estimate impulse response functions, and the Granger causality lest to find out the direction of causality between reserve money (central bank's operational target) and real GDP gap and reserve money and inflation. Both tests confirm that the above hypothesis cannot be rejected. The second objective is to estimate the central bank's money reaction function. It is found that the monetary authority's degree of leaning against the wind is almost zero.