On the Temporal Causal Relationship Between Macroeconomic Variables

Srinivasan Palamalai,Christopher Devakumar,Kalaivani Mariappan

doi:10.1177/2158244014525419

Abstract

The present study examines the dynamic interactions among macroeconomic variables such as real output, prices, money supply, interest rate (IR), and exchange rate (EXR) in India during the pre-economic crisis and economic crisis periods, using the autoregressive distributed lag (ARDL) bounds test for cointegration, Johansen and Juselius multivariate cointegration test, Granger causality/Block exogeneity Wald test based on Vector Error Correction Model, variance decomposition analysis and impulse response functions. The empirical results reveal a stronger long-run bilateral relationship between real output, price level, IR, and EXR during the pre-crisis sample period. Moreover, the empirical results confirm a unidirectional short-run causality running from price level to EXR, IR to price level, and real output to money supply during the pre-crisis period. Also, it is evident from the test results that there exist short-run bidirectional relationships running between real output and EXR, price level and IR, and IR and EXR in the pre-crisis era, respectively. Most importantly, long-run bidirectional causality is found between real output, EXR, and IR during the economic crisis period. And the study results indicate short-run bidirectional causality between money supply and EXR, IR and price level, and IR and output in India during the crisis era. Also, a short-run unidirectional causality runs from prices to real output in the crisis period.

Highlights

The relationship among money supply, income, and prices has long been a subject of controversy between the Keynesian and monetarist schools of thought
For the pre-crisis period, the table results confirm that variables, prices (CPI), and interest rate (IR) are stationary at levels and are integrated of order I(0), while industrial production (IIP), money supply (M3), and exchange rate (EXR) are integrated of order I(1), that is, they are non-stationary at levels but stationary at first differences
For the economic crisis period, the table result reveals that all the selected macroeconomic variables are found to be stationary at their first differences and are integrated at I(1)

Summary

Introduction

The relationship among money supply, income, and prices has long been a subject of controversy between the Keynesian and monetarist schools of thought. The Keynesians held the view that money does not play an active role in changing income and prices nor does it causes instability in the economy. They postulated that changes in income causes changes in money stock via demand for money implying that the direction of causation runs from income to money, not vice versa. Monetarists, on the contrary, argued that money plays an active role and leads to the changes in income and prices. The Banking school supported the reverse causation between money and income, thereby arguing for endogeneity of money supply (Froyen, 2004)

Methods

Results

Conclusion