JUJSS
Vol. 31, 2012, pp. 25-34
Influence of Monetary Base on Economic Growth: An Empirical Study for the Determination of the Forecasting Model
Helal Uddin Ahmed
School of Business, South East University, Dhaka, Bangladesh Abstract
The policy makers, researchers and business leaders always face a question that how the economy is moving at the deployment of probable movers of economy during a certain period of time. The problem may be spelled out and its possible solution may be found by adjucating the researches by asking the stakeholders directly or through using the already built up information. With this view, in this study it is desired to observe the volatility in income velocity at the change of income (from 1% to 5%) under constant monetary bases M1 and M2; to identify the order of integration of M1, M2, inflation rates measured by CPI and exchange rates; to infer about the simultaneous influence of exchange rates and inflation rates on the monetary bases M1 and M2, and finally to select a model in forecasting the monetary base M2 in Bangladesh. This study used the yearly data on M1 and M2 for testing the volatility as well as used the quarterly data on M1, M2, inflation rates measured by CPI, and exchange rates for testing the interdependence of the monetary base using VAR model.
The fitted model indicates that the incremental capital-output ratio may bring about sustainable growth while the inflation rates and exchange rates shown to play a signaling role in setting up the monetary base.
Keywords and Phrases: Economy, development, income velocity, inflation, CPI, capital-output ratio.
1. Introduction
The most appealing guides for the monetary policy are the exchange rates, the price level as defined by some index, and the quantity of total currency plus adjusted demand deposits or this total plus the commercial bank time deposits. The propensity to overreact is very clear: the failure of monetary authority to allow the delay between their actions and the subsequent affects on the economy (Friedmen, 1968). The authority may take their actions by today’s conditions but that actions may affect the economy only six or nine or twelve or fifteen months later. So, they feel to step on the brake, or the accelerator, as the case may be too hard. They go all the way in avoiding such swings by adopting the policy of achieving a steady rate of growth in a specified monetary total. The precise rate of growth, like the total of monetary base is less important than the adoption of some stated and known rate. The rate that would on the average achieve rough stability in the level of price of the final products, which is estimated to be 3 to 5 per cent per year rate of growth in currency plus commercial bank deposits a slightly lower rate of growth in currency plus demand deposits (Friedmen, 1968). The periods of relative stability in the rate of monetary growth have also been periods of relative stability in economic activity in the United States and in other countries. The monetary authority could make a major contribution in promoting economic stability by making a moderate growth in the quantity of money avoiding either
inflation or deflation of prices. However, to break the cycles of poverty investments are necessary that require the resources for today to increase productivity for tomorrow (Samuelson, 2005).
Harrod and Domar growth model (Harrod 1948, Domar 1957) pointed out that there are three concepts of growth. The first is the warranted growth rate at which the firms believe that they have the right amount of capital and do not feel the necessity to increase or decrease the investment given their expectations of future demand (capital-output ratio). The second is the natural rate of growth, which corresponds to the increase in the labour force; the labour force rises, growth must rise to maintain the full employment level. The third is actual growth of the change in the aggregate output that finally materializes.
Keynes (1936) pointed out that the imports are determined by the domestic income and output, by the ratio of domestic to foreign prices and by the exchange rates. Exports are the mirror image of imports, determined by the foreign incomes and output, by the relative prices and by the foreign exchange rates.
The net exports will then be determined by domestic and foreign incomes, relative prices and exchange rates.
The income velocity of money gives the idea about the number of times a certain amount of money turns for producing a quantity of output. It is often observed that ambitious political institutions target the real variable like output for explaining their attachment to the people, sincerity, honesty and commitment to the nation while making their budget for upcoming period. In doing so, the growth is targeted first thereafter do use different policies in attaining the targeted growth.
This might lead to a question - how things are moving ahead by fixing the growth rate first? The aspiration may bring about a change if the consumption and investment, price level, exchange rate, interest rate may be maintained at their respective desired levels. So to materialize this commitment transparency and people’s participation are required to be ensured in implementing the development programs.
Fischer (1996) pointed out that an expansionary fiscal policy raises interest rate thereby to dampening its expansionary impact. If it is only to dampen rather than offset the expansionary effects of fiscal policy then the composition of aggregate demand between consumption and investment spending depends on the change of interest rate. The higher interest rate dampens the aggregate demand mainly by reducing the investment. Thus, an expansionary fiscal policy tends to raise consumption (through multiplier) however, tends to reduce the investment. The decline in the component of investment affects the growth of the economy. The side effect of fiscal expansion called “partial crowding out” is an important but sensitive issue in policy making.
The sources of fund financing of the budget deficits are loans and grants from overseas, and banks and individuals through open market operation. A two-way interaction usually exists between budget deficits
and inflation. Higher deficits tend to cause higher inflation, since a part of the deficits is financed by printing money. On the other hand, higher inflation results in higher deficits by reducing the real value of tax collections. Again higher nominal interest rates raise the size of deficits by increasing the size of interest payment on the outstanding debt due to the cumulative budget deficits. The American redistributive system of taxes and transfers is characterized as a leaky bucket (Okun, 1970). The size of the leakages may be quantified by examining the major inefficiencies induced by high tax rates and by generous income support programs: administrative costs, damages to work and saving incentives and socio-economic costs.
So does, only an empirical study may suggest the path to identify and control the trembling variables such as monetary base M1, monetary base M2, inflation rates measured by CPI, exchange rates, interest rates, etc. The swinging of income velocity (at the change of output holding other things constant) and the influence of exchange rates, interest rates and inflation rates on the monetary base may be included as a means of undertaking the present study.
2. Data and Methodology
The data on growth rate of real GDP, M1 and M2, spread of interest rates, and exchange rates are collected for the period 1996-2010 from the Economic Trend published by Bangladesh Bank, and the Bangladesh Economic Survey published by the Ministry of Finance, Government of Bangladesh. Such data are available as time series data. These often have large positive and large negative observations and tend to appear in cluster (Frances, 1998). The heterosecdasticity may have an autoregressive structure observed over the different periods may be autocorrelated (Engle, 1982). So, the swinging of time series can be quantified by developing ARCH (autoregressive conditional heterosecdasticity) model.
In order to have better understanding of the interrelation among the variables the velocity of money, interest rate, CPI and M2 data for the period 1995-2012 are taken into consideration primarily. The income velocity, interest rate, CPI and M2 maintain linear trend over the time period considered (Figure 1- 4). The income velocity of money shows a declining trend (Figure 1) whereas the interest rates show ups and downs in the series with a declining trend too (Figure 2). (This study attempts to discuss the effect of income velocity of money to integrating monetary and fiscal policy.)
The CPI indicates an increasing trend (Figure 3) while the monetary base M2 show ups and down but also with an increasing trend in the data for the considered period. (This study attempts to rationalize the movement of these variables.)
This study attempts to study the volatility in the income velocity of money as the contribution of the monetary base, and the increment of GDP in percentage. The technique of ARCH model is used in computing the volatility. In this regard, the following ARIMA (1, 0, 0) or AR (I) model is used to quantifying or characterizing the volatility in the current period which is related to its value in the previous period plus a white noise term
2 2
1 2 1
t t t
x x u . (1)
where
x
t2 is the measure of volatility with xt2 dy*t dyt* where dyt*yt*yt*1 is the relative change in the velocity y yt( t*logyt);dyt* is the mean ofy
t*.Figure 2. Interest rate of Bangladesh
0 5 10 15
1995 2000 2005 2010 2015
Year Interest rate
Interest rate Figure 1. Income velocity of money
0 1 2 3 4
1995 2000 2005 2010 2015
Year Velocity
Velocity
Figure 4. M2 money of Bangladesh
0 5 10 15 20 25
1995 2000 2005 2010 Year
Growth
Growth Figure 3. CPI of Bangladesh
0 50 100 150 200 250
1995 2000 2005 2010 Year
CPI
CPI
Gujarati (1995) pointed out that the quantification of volatility is done by measuring the significance level of2. For positive 2, the existence of volatility in the past period indicates that it will continue to be high in the current period that resembles volatility clustering. For β2 = 0, there will be no volatility clustering. The statistical significance of estimated β2 can be judged by the usual tests.
The financial and economic time series move on with their own momentum which to settle at a point of full employment level. It does not move further from its equilibrium level unless any program is injected from outside. On the contrary financial variables and economic variables are interrelated. To visualize this inter relationship along with the lagged terms it is attempted to estimate the parameters of the following models and interprete the results in the context of cotemporary economic conditions
Mt = /
1
1 1 1
k k k
j t j j t j j t j t
j j j
M I E U
It = // 2
1 1 1
k j t j
k j t j
k j t j tj j j
M I E U (2)
Et = /// 3
1 1 1
k k k
j t j j t j j t j t
j j j
M I E U
where M = stock of M1 and M2, I = inflation rate, E = exchange rate, , , , are the constants and U’s are random variables in individual levels with mean zero and common variance 2.
3. Results and Discussions
The results representing the volatility in income velocity of M1 and M2 monetary bases are given in Table 1 and Table 2 respectively. The estimates of the parameters of each of the models in (2) are obtained for the existing real GDP series for each of the increased level by 1.5, 2.5, 3.5 and 5.0 per cent.
The volatility co-efficient 2is found to be positive and significant at all incremental levels for both M1 and M2 bases. This means that the volatility was present in the previous period and is being sustained in the current period. The model selection criteria such as F, AIC, BIC and DW are found to be significant at respective significance levels. So, it may be concluded that the growth can be warranted by using the incremental capital output ratio provided that the right amount of resources has been invested and is not required to change the given expectation of future demand. It is observed that the estimated volatility2based on M1 at all incremental levels of output is found to be significantly higher compared to M2 monetary base. The higher volatility may creeps due to the variability in the interest rates, price levels, exchange rates, political instability, unpredictable inflows of FDI and remittances from overseas destinations.
Table 1: Estimated volatility in GDP/M1 at the participation of M1 and the estimated model selection criteria
Co-efficients Percentage of increment of existing output
1.5 2.5 3.5 5.0
1
(t - value) p - value
0.001 (1.086)
0.299
0.001 (1.084)
0.300
0.001 (1.085)
0.299
0.001 (1.083)
0.300
2
(t - value) p - value
0.860 (3.374)
0.000
0.861 (3.379)
0.005
0.860 (3.377)
0.005
0.861 (3.383)
0.005
R2 0.487 0.488 0.487 0.488
Adjusted R2 0.444 0.445 0.445 0.445
DW 1.177 1.178 1.177 1.178
F (p - value)
11.384 (0.000)
11.416 (0.005)
11.404 (0.005)
11.442 (0.005)
RSS 0.0001 0.0001 0.0001 0.0001
AIC -54.000 -54.000 -54.000 -54.000
BIC -57.648 -.57648 -57.648 -57.648
The higher per capita M1 money may influence the underground businesses. On the other hand, the higher per capita M2 money indicates higher investment that integrates income generating activities and mobilizes the small, medium and large industries in creating employment and stabilizes the price level. In this regard, this study attempts to find an appropriate forecasting model for M2 monetary base. In doing so, the parameters will be tested for one, two, three, and four lags using the vector autoregression (VAR) technique however, the ordinary least squares method will be used to estimate the model parameters. In this regard, three different models are fitted by using three different dependent variables M2 (along with inflation rates and exchange rates), inflation rates (along with M2 and exchange rate) and exchange rates (along with M2 and inflation rates) with a sample (adjusted) of 5 38 with included observations 34 after adjustments with the same levels of lags.
Table 2: Estimated volatility in GDP/M2 at the participation of M2 and the estimated model selection criteria
Co-efficients Percentage of increment of existing output
1.5 2.5 3.5 5
1
(t - value) p - value
0.001 (0.933)
0.369
0.001 (0.933)
0.369
0.001 (0.933)
0.369
0.001 (0.932)
0.370
2
(t - value) p - value
0.756 (5.051)
0.000
0.756 (5.054)
0.000
0.756 (5.055)
0.000
0.756 (5.058)
0.000
R2 0.680 0.680 0.680 0.681
Adjusted R2 0.653 0.654 0.654 0.654
DW 1.295 1.295 1.295 1.295
F (p - value)
25.511 (0.000)
25.547 (.000)
25.557 (0.000)
25.588 (0.000)
RSS 0.0001 0.0001 0.0001 0.0001
AIC -54.000 -54.000 -54.000 -54.000
BIC -57.648 -.57.648 -57.648 -57.648
Table 3: Vector autoregression estimates of the M2 monetary base due to four lags with sample (adjusted) of 5 38 with included observations 34 after adjustments with the same levels of lags
Variable Coefficient Standard Error t-Statistic Probability
Constant -18489.56 11008.01 -1.679646 0.1078
M2(-1) 0.475176 0.156135 3.043374 0.0062
M2(-2) 0.006626 0.194288 0.034105 0.9731
M2(-3) -0.238857 0.180543 -1.322990 0.2001
M2(-4) 0.870208 0.173435 5.017480 0.0001
Exrate(-1) -389.9336 466.2679 -0.836287 0.4124
Exrate(-2) 1245.748 674.9717 1.845630 0.0791
Exrate(-3) -949.3062 684.6937 -1.386468 0.1801
Exrate(-4) 423.5008 532.0360 0.796000 0.4349
Infrate(-1) -1260.837 382.9296 -3.292608 0.0035
Infrate(-2) 97.62107 431.1220 0.226435 0.8231
Infrate(-3) 554.9199 442.7088 1.253465 0.2238
Infrate(-4) 455.8490 423.5379 1.076289 0.2940
R2 0.999458 Mean dependent var 174325.9
Adjusted R2 0.999149 S.D. dependent var 68052.06
S.E. of regression 1985.560 AIC 18.30806
SSR 82791456 Schwarz criterion 18.89167
Log likelihood -298.2370 F-statistic 3228.596
DW 1.986628 p-value (F) 0.000000
The first and fourth levels of lags of M2, exchange rates at first level and inflation rates at first level are found to be individually significant (Table 3). The F value is found to be highly significant. This means that jointly the lags of M2, exchange rates, and inflation rates influence the current M2 money significantly however the value of AIC and BIC are found to be very low.
Individually, the fourth lag of the M2, the fourth lag of the exchange rates and the inflation rates at first lag are found to be highly significant (Table 4). The value of F is found to be significant. Moreover, the R2, DW, AIC, and BIC of the regression are found to be significantly low. All these values support that the lag of inflation rates, exchange rates and M2 monetary base influence the current inflation rates.
Individually, the exchange rates at fourth lag shows significant influence on the exchange rates. The value of R2 and F values are found to be sufficiently large. On the other hand, the AIC and BIC are sufficiently low. So, it may be concluded that the exchange rates are influenced by the M2 monetary base and inflation rates.
Table 4: Vector autoregression estimates of the inflation rates due to four different lags
Variable Coefficient Standard Error t-Statistic Probability
Constant -15.35792 6.397161 -2.400740 0.0257
M2(-1) 4.93E-05 9.07E-05 0.543693 0.5924
M2(-2) -0.000173 0.000113 -1.530892 0.1407
M2(-3) -8.90E-05 0.000105 -0.848256 0.4059
M2(-4) 0.000206 0.000101 2.043708 0.0537
Exrate(-1) 0.228639 0.270965 0.843795 0.4083
Exrate(-2) -0.160286 0.392251 -0.408631 0.6869
Exrate(-3) -0.373414 0.397901 -0.938461 0.3587
Exrate(-4) 0.664447 0.309186 2.149023 0.0434
Infrate(-1) 0.461140 0.222534 2.072216 0.0507
Infrate(-2) 0.181940 0.250541 0.726190 0.4757
Infrate(-3) -0.204519 0.257274 -0.794946 0.4355
Infrate(-4) -0.114833 0.246133 -0.466547 0.6456
R2 0.787937 Mean dependent var 6.453529
Adjusted R2 0.666758 S.D. dependent var 1.998856
S.E. of regression 1.153882 AIC 3.407009
SSR 27.96033 Schwarz criterion 3.990618
Log likelihood -44.91916 F-statistic 6.502252
DW 2.295450 p-value (F) 0.000105
By using the actual values of financial and economic indicators and the real balance demand model (L kYhi) the sensitivity of money demand and sensitivity of real balances are estimated for the three different periods 1996-2000, 2001-2005 and 2006-2010 (Table 6). This may shed some light on how much the financial market get accelerated or retarded at the rates of inflation. The analyses have shown that during the period 2001-2005 the market had low inflation rates while the interests reduced to Tk.18046 crores of investment which is significantly lower than the other two periods. But at the inflation rates of 4.69 and 7.65 the investment sizes were reduced by Tk. 34737.02 crores and Tk. 46035.2 crores, respectively. So, along with the exchange rates necessary measures to be adopted to maintaining the inflation rates at such a level so that the demand of real balances could move forward according to the requirements of the economy as measured by its absorption capacity.
Table 5: Vector autoregression estimates of the exchange rates due to four different lags
Variable Coefficient Standard Error t-Statistic Probability
Constant 7.748709 5.012745 1.545802 0.1371
M2(-1) 3.30E-05 7.11E-05 0.464378 0.6472
M2(-2) -5.80E-06 8.85E-05 -0.065565 0.9483
M2(-3) 8.20E-05 8.22E-05 0.996829 0.3302
M2(-4) -0.000109 7.90E-05 -1.378560 0.1825
Exrate(-1) 1.098896 0.212326 5.175524 0.0000
Exrate(-2) -0.168269 0.307363 -0.547460 0.5898
Exrate(-3) 0.322215 0.311791 1.033434 0.3132
Exrate(-4) -0.404981 0.242275 -1.671580 0.1094
Infrate(-1) 0.071481 0.174376 0.409925 0.6860
Infrate(-2) 0.150074 0.196321 0.764431 0.4531
Infrate(-3) -0.107106 0.201597 -0.531287 0.6008
Infrate(-4) 0.036480 0.192867 0.189144 0.8518
R2 0.980511 Mean dependent var 64.01971
Adjusted R2 0.969375 S.D. dependent var 5.166640
S.E. of regression 0.904169 AIC 2.919268
SSR 17.16797 Schwarz criterion 3.502876
Log likelihood -36.62755 F-statistic 88.04446
DW 2.136124 p-value (F) 0.000000
Table 6: Major financial and economic indicators in Bangladesh
Indicator Period
1996-2000 2001-2005 2006-2010
GDP at current Market Price (million TK.) 202196.6 306201.4 548243.00
Income velocity of M1 base 12.23 11.00 8.94
Income velocity of M2 base 3.48 2.63 2.10
M1 (million TK.) 16529.12 27820.76 61309.80
M2 (million TK.) 57995.40 116190.60 260100.80
Income elasticity of money 0.391 0.542 0.649
Sensitivity of interest rate - 34737.2 - 18046.0 - 46035.2
Inflation rate 4.69 4.28 7.65
Income sensitivity of money demand 0.289 0.379 0.474
4. Policy Recommendations
An anticipated inflation tends to increase the total spending at the expense of savings however, an unanticipated one reflects the reverse effects on the economic indicators. So, necessary measures ought to be taken like the avoidance of ineffective investment which may often included in the development projects and programs without checking its feasibility.
The average per capita M1 for the period 2006-2010 is found to be at Tk 3,802 which is 85 per cent higher than its value for the period 2001-2005. The larger fraction of the outstanding currency is not held by the households or at least they do never reveal to hold it. Albeit, a significant portion of it is held by the legitimate business however the rest is held to finance illegal trading particularly drug and other scarce and low priced commodities. The current slump in stock markets and the liquidity problem indicate the unexpected illegal trading in the country. So, the size of M1 must be carefully handled to maintain the congenial price level required for the warranted growth of the real GDP.
The velocity of money is either stable or in extreme case should be constant. If it is stable, the monetary bases M1 and M2 will determine the nominal GDP. So does the fiscal policy becomes ineffective because the only factor PQ remains in the equation and is influenced by M (M1 and M2). If it is constant, the fiscal policy (taxes or government expenditures) does not have any role to paly in the economy. On the other hand, if the velocity increases the economy may be delt with either expansionary or contraction monetary policy. In Bangladesh, the velocity of money tends to decrease gradually where the expansionary monetary policy is practiced since 1975. This results in high inflation rate. So, the country should explore the efficiency of contractionary monetary policy at least for short-run duration.
The contractionary money base situation affects both the output and prices in the short-run. So, the economy tends to move towards full employment level with its system of operations. So does the fiscal policy have a room to affect the output and prices both in the short-run and long-run.
The analysis shows that the economy is influenced by the M2 monetary base, exchange rates and inflation rates however highly by the M2. So the variables which may influence the M2 should carefully be handled to have sustainable economic growth in Bangladesh.
The prices of luxurious and durable goods, stock markets, lands and per square feet construction of houses, better health and education services should be made accessible to the greater number of people.
The accountability, transparency and public participation in the implementation of capital investment to be increased ensuring the commitment of government policies laid down in the fiscal policy for the specific period. These may help to reduce the illegal, unsocial, and unethical activities in the country. So, a constant flow of liquid resources (the expected size of M1 and M2) will act more effectivity in
enhancing the growth of the maintained economy to achieve the desired stability of the inflation rate and exchange rate.
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