Impact of Money Supply on Aggregate Price Levels: Evidence from Sri Lanka

Abstract

The effect of a stock of money on agricultural prices has been a crucial issue in recent discussions on the effectiveness of macro-economic policies on the agricultural sector. The agricultural price level is important because it influences the supply and demand of agricultural products. Theoretically it is widely accepted that the money supply is positively related to the price level in the short form and this effect is neutralized in the long-run leaving real variables i.e. output, employment and income unaffected. The short-run impact of an increase in the money supply, theoretically, has two components: (1) increase employment and output, and (2) increase in price levels. Empirical tests for effects of money supply on agricultural prices, however, have yielded mix results. Some researchers have found evidence on the positive effect of the money supply on agricultural prices while others have reported that relative agricultural prices are not affected by changes in the nominal stock of money. Since the issue is inconclusive so far, it is germane to shed more light on the relationship between these two variables under various circumstances. Monthly data on the money supply and aggregate price levels (for all commodities and food items) of the Consumer Price Index from 1970 to 1990 were used for the analysis. The same price data from the Whole Sale Price Index from 1978 to 1990 were also used for the analysis. Narrow money supply and broad money supply were used to fit Vector Auto Regression (VAR) models to examine the dynamic relationship between the money supply and prices in Sri Lanka. Resource reveal that there is no statistically significant causal effect of the money supply and aggregate food prices in both price indices for the given period of time. The Consumer Price Index for all commodities, however, shows a causal relationship to changes in the money supply. The price index of all items in WPI also does not have a significant response to the changes in the stock of money. This raises the question as to how effective would the increase in the money supply be, as a macro-economic stabilization policy in manipulating the agricultural sector in the country.