The Long–Run Relationship Between Money Supply, Real

GDP, and Price Level: Case of Canada (Part B; time-

series)

MSc Economics and Financial Economics

Module: L14009 Economic Data Analysis

Ayesha
UNIVERSITY Javed
OF NOTTINGHAM
School of Economics
Table of Contents
Introduction...........................................................................................................................................2
Theoretical framework..........................................................................................................................2
Hypothesis.............................................................................................................................................3
Data.......................................................................................................................................................4
Methodology.........................................................................................................................................4
Empirical Results....................................................................................................................................4
Test for stationarity............................................................................................................................5
Cointegration test..............................................................................................................................6
Granger Causality test........................................................................................................................7
Conclusion.............................................................................................................................................8
References.............................................................................................................................................9
Appendix.............................................................................................................................................10
Introduction.
The importance of analysing the relationship between income, price level, and money supply
lies in its significance to researchers, economists, and policy makers alike. This is because
once a clear understanding of the interplay between these variables is established it can aid
policy makers in implementing those polices that serve the purpose of effective
macroeconomic stabilization. Previously the matter has been approached with various
econometric tools; exploration of the existence of causality and the direction in which it lies
between the mentioned variables.
There has been extensive studies done on the particular topic for various countries over the
years but it still one that is quite debated. This paper tries to utilize some methodologies that
have been previously employed in the context of Canada between the periods 1996 and 2016.
It employed co-integration analysis and granger causality test to explore the long-run
relationships between money supply, income, and inflation.
The structure of the following material is as such: section 2 will provide insights regarding
the salient features of Canada’s economy in the discussed time period. Section 3 will
elaborate on the theoretical framework that backbones this analysis. In the fourth section the
hypothesis of the study and the related methodology used will be discussed, along with the
results of related statistical analysis. After which conclusory remarks will be given.

Theoretical framework
It is widely agreed upon that income, inflation, and money supply are significant
macroeconomic variables, and have a crucial role in a stabilized economy. Hence,
understanding the dynamic of causality between the mentioned variables becomes a matter of
importance, especially for policy implementation.
The matter of the direction of causality between these three variables has resulted in
bifurcated theoretical frameworks. On one hand, it is claimed by monetarists that money does
indeed have an active role and it results in the fluctuations in income and price levels. They
say that it is because of money supplies that an economy experiences fluctuations in income
and prices. In their view the direction of the causality is from money to inflation and income.
The Keynesians, however, argue that contrary to what the Monetarists states, money does not
have an active role when it comes to shifts in neither money supply nor price level. They
propionate that it is the change in income that causes changes in money supply. Also, that
changes in inflation are a result of structural factors.
The matter has been analysed with varying techniques. Sims (1972) used the causality test
developed by Granger, which at the time was not very commonly used. The test was used to
demonstrate existence of a unidirectional causality between money supply and income. Sims
applied the technique to data from U.S.A. His findings were that in the post-war period there
can be observed a causality between money and income; that is directed from money to
income. This was in support of the claim of the Monetarists.
In 1983, Lee and Li, analysed the same relationship in the context of Singapore. There
findings were as such; there exists a unidirectional causality when it comes to money and
prices, and the direction of it is from money to prices, however when concerned with income
and money, the causality is bidirectional.
Joshi and Joshi (1985) also concluded a similar study in India and concluded that the
relationship between income and money was bidirectional in its causality. Khan and Siddique
(1990) used granger’s causality to analyse. They concluded there did exist a unidirectional
causality between income and money, with the direction being from income to money. They
also conclude that the causality between money and prices was bidirectional. Salih (2013) did
analysis in Saudi Arabia between 1968 and 2011 and concluded that there existed
bidirectional causality when it came to income and money. Whereas there was a
unidirectional causality from income to prices and from prices to money. He applied both
VAR models and Granger causality in the conduction of their analysis.
The review of previous work done in the area is highly contradictory and inconclusive.
Nevertheless, it is the importance of the very concept that has encouraged analysis in the
matter even in recent years.

Hypothesis
The paper aims to draw a conclusion view econometric tools on the relationship between the
significant macroeconomic variables; money supply, prices, and income. The hypothesis is
two folds. Firstly, the study tries to conclude whether the causality between prices and money
supply is from the direction of prices to money supply or the other way around.
Equations (1) and (2) represent this hypothesis: M1 is taken as money supply and consumer
price index is used to represent prices
n n
M 1t =∑ α i CPI t−i +∑ β j M 1t − j +ε 1 t (1)
i=1 j=1

n n
CPI t =∑ γ i CPI t −i +∑ δ j M 1t − j +ε 2 t
i=1 j=1 (2)

Secondly, what is the direction of the causality between money supply and income? Is the
causality in the direction of money supply to income or the opposite?
Equations (3) and (4) represent this hypothesis: real GDP is used to represent income.
n n
RGDPt=∑ ai M 1t−i + ∑ b j RGDPt− j + ε 3 t (3)
i =1 j=1

n n
M 1t =∑ c i M 1t −i + ∑ d j RGDPt − j + ε 4 t
i=1 j=1 (4)

The nature of this hypothesis will be determined using the granger causality test.
The analysis will not include multivariate causality between the three variables. For an
analysis like that Vector Autoregression technique is used which will not be used in this
particular study.
Data
Time series secondary data is used for the purpose of this analysis. The data was taken from
the OECD database for Canada. It is quarterly data from q1 1996 till q4 2016. The data
includes variables M1 money supply, CPI, and real Gross domestic Product.

Methodology
Unit root test will be administered to check the stationarity of the three variables under
consideration. For this purpose the Augmented Dickey-Fuller test will be used. It is important
to undergo this part of the analysis so that the problem of spurious regression may be
avoided. It is also important that time series should be stationary as it is an underlying
assumption of the causality test and without this assumption holding, said test cannot be
applied to the data. The stationarity of a time series has a significant impact on the way a
variable behaves and the properties that can be associated with it.
Co-integration test will be done in order to determine the existence of relationship between
real GDP, money supply, and prices. Engel-Granger test, with its two step analysis, will be
used for this.
Granger Causality test will be used to test the two hypothesis that have been mentioned in the
sections above; what is the direction of the causality between money supply and GDP, and
what is the direction of the causality between money supply and GDP.

Empirical Results
When the three variables in question are plotted against time we get the following time series.
When plotted against time we can see that M1 shows an exponential increase over time,
though not linear. With CPI the trend is more fluctuating with huge shifts between end of 70
and till mid 80s. There has been a general decreasing trend in the real GDP in Canada. The
trend is fluctuating though.

Figure 1: Canada quarterly Money supply (M1)

 Figure 2: Canada quarterly CPI

Figure 3: Canada quarterly Real GDP

Test for stationarity

Unit root test is aimed at finding whether a series is stationary or not. For the three variables
in question, Augmented-Dickey fuller test will be employed to analyse whether they have
unit root or not. Information criteria (IC) was used to determine the choice of lag order for the
test. The variables will be analysed at levels.
 ADF test (In levels)

Real GDP -4.246**

Money Supply 5.967**
Price level -2.005*

Notes:
- Null hypothesis is that there is unit root.
- ** denotes that null hypothesis has been rejected at both 1% and 5% level of
significance.
- * denotes that null hypothesis has been rejected only at 5% level of significance.
All variables are stationary at 5% level of significance in their level forms.
Cointegration test
Engel-granger test is run to see whether a linear combination of two variables is stationary or
not. The linear relationship between money supply and CPI will be analysed as well as the
linear relationship between GDP and money supply. Engel-granger test is a two-part process
First we will analyse whether there exists cointegration between real GDP and money
growth. Money growth will be regressed onto real GDP. The residuals from this regression
will be estimated and the Augmented-Dickey fuller test will be applied to these residuals. The
null hypothesis is that there is unit root/spurious regression.
When finding the cointegration between real GDP and money growth, the results are as
follows.

1% level of 5% level of 10% level of

significance significance significance
-3.885 Reject H0 Reject H0 Reject H0

When finding the cointegration between money growth and prices, the results are as follows:

1% level of 5% level of 10% level of

significance significance significance
0.911 Do not reject H0 Do not Reject H0 Do not Reject H0

The Engel-granger test allows for only one cointegrating relationship. This is why it would be
a better analysis if the Johansen test were to be applied to this but this test is beyond the
scope of the study and, hence, shall not be applied. Although it is noted that said test would
be a better parameter for this particular case.
The results imply that though there is a long-run cointegration relationship between real GDP
and money growth, there does not exist one between money growth and prices. Real GDP
and money growth are cointegrated in the long-run.
Granger Causality test
To be able to apply the granger causality test, it is assumed that the series are stationary and
do not possess unit root. We also assume that ε 3 t and ε 4 t (from equations 3 and 4) are
uncorrelated. To test the hypothesis represented by equations (3) and (4) the granger causality
test will be used. Both these equations represent a vector autoregressive model. Information
Criteria is once again used to decide the lag order for the model.

Equation Excluded Chi2 Df Prob > chi2

M1 money
Real GDP 5.0873 1 0.024
growth
Real GDP All 5.0873 1 0.024

H0: lagged (1) M1 money supply does not cause Real GDP
Ha: lagged (1) M1 money supply does cause Real GDP
Conclusion: We can reject null hypothesis according to the results.

Equation Excluded Chi2 Df Prob > chi2

M1 money growth Real GDP 0.50298 1 0.478
M1 money growth All 0.50298 1 0.478

H0: lagged (1) Real GDP does not cause M1 money supply
Ha: lagged (1) Real GDP does cause M1 money supply
Conclusion: We cannot reject null hypothesis according to the results.
The relationship between money growth and prices that is represented by equations (1) and
(2) will be no be analysed because the cointegration test concluded that there is no long-run
relationship between the two for this particular data sample.
The granger causality test concludes that there is a unidirectional relationship between real
GDP and money supply and the direction of this causality exists from M1 Money supply to
real GDP. In other words, the shifts experienced in the money supply can have real affects in
the economy.
Conclusion
Quarterly data for Canada between 1996q1 and 2016q4 is analysed. Unit root test is applied
to test the stationarity of the three variables. It was concluded that all three variables are
stationary. This test was performed because the assumption of stationarity is an important one
for the basis of granger causality test, and it is necessary to be able to apply the test.
Cointegration test was applied to see whether there exists long-run relationship between real
GDP and M1 money supply, and between M1 money supply and CPI. There did exist a long-
run relationship between the former but this was not the true in the case of latter, according to
this study. Hence, the granger causality test was applied only on M1 money growth and real
GDP. The conclusion was that there exists a unidirectional relationship between the two, with
the direction of causality existing from M1 Money supply to real GDP.
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Appendix
ADF test CPI

ADF test for GDP

ADF test for money growth
Cointegration
Granger causality test