Money, Income, and Causality: Some Evidence from Pakistan

Abstract

The role of money in determining the level of economic activity has long been debated among economists. The classical economists were of the view that the changes in the money supply can only affect the monetary variables like the price level and nominal wage rates but cannot influence real output. J. M. Keynes and his followers asserted that changes in money supply do influence the level of real output through their effect on the rate of interest and thereby changing investment expenditure. However, by introducing the idea of a liquidity trap and by making investment as highly interest inelastic, Keynes did not assign any active role to money. Milton Friedman and his followers, known as the Monetarists, raised the slogan that "money does matter" and thus tried to assign a dominant role to money supply in determining the level of economic activity. They assert that changes in money supply have a dominant influence on changes in nominal income. They are of the view that in the short run money does influence real output and employment and thus money is the dominant factor causing cyclical movements in output and employment. However, they believe like the classical economists, that in the long run the changes in money primarily influence the price level and other nominal magnitudes.