Causality Test between Money and Income: A Case Study of Selected Developing Asian Countries (1960-1988)

Abstract

Money supply in developing countries, like Pakistan plays an important role. According to classical theory, supply creates its own demand. Any increase in money supply will give rise to increase in prices only but the effect on output will remain unchanged. The Keynesians argue that aggregate demand determines output, therefore, fiscal policy is more important. The monetarists on the other hand, argue that in the short run money and only money matters. In the case of the rational expectation approach, anticipated changes in money supply are neutral but short-run unanticipated changes in money supply have a role in determining the growth of output. Monetary policy is an effective instrument in the hands of government to obtain the desired targets such as level of output, unemployment, and prices. Therefore, it is very important to know whether changes in money supply cause changes in output or vice versa. In other words, we have to identify the direction of the causality. If both variables are serially correlated with each other then we cannot use any of them as a determinant of the other.