Impact of Institutional Factors on the Long-run Behaviour of Money Velocity in India

Abstract

The objective of the study is to examine the impact of institutional changes in the financial sector on the long-run behaviour of broad money velocity in India. For this purpose, annual time series data from 1970–1971 to 2019–2020 has been used. To avoid the problem of multicollinearity, three institutional factors (urbanisation ratio, ratio of total deposits to currency and DCPS) have been combined to form an institutional factor index using PCA. The unit root results indicate that variables are a mix of I(0) & I(1), therefore, ARDL-ECM methodology is applied. Results indicate that money velocity exhibits a structural break in 2008, conforming to the global economic crises. To examine the impact of institutional factors a benchmark model (BM) containing per capita GDP and rate of interest has been estimated along with an institutional factors model (IFM) which also contains institutional factors index. The results show that there is no co-integration in BM, whereas co-integration was established in IFM. The error-correction term and institutional factors index were highly significant for IFM, confirming the long-run relationship. The explanatory power (adjusted R2) for IFM was considerably higher than BM, indicating that the addition of institutional variables significantly improves the money velocity model for India. JEL Codes: C32, E41, E52