Dynamic Causal Interactions of Money, Prices, Interest Rate and Output in Pakistan

Abstract

Monetary policy has remained one of the most fundamental topics in macroeconomics. Since the beginning of macroeconomic history it has been argued that money has a strong role in affecting the real economic activity but the evidence remains inconclusive. Considerable empirical evidence has been produced on the stance of monetary policy using different approaches and still the process continues. The present study investigates the dynamic interactions among macroeconomic variables such as money supply, prices, interest rate, exchange rate and output level, using the quarterly data for Pakistan over the period 1972Q1 to 2009Q4. For the empirical analysis the Johansen multivariate cointegration technique, Granger causality test and variance decompositions are employed. The results from the cointegration test indicate that there exits a stable long run equilibrium relationship among the macroeconomic variables of the study. The outcome of causality tests tends to support the non neutrality of money view of the Keynesians and the Monetarists at least in the short run. Furthermore, it is seen that there exists a bi-directional causality between money supply and price level, and interest rate and price level. While, a unidirectional causality runs from money supply to output level and interest rate, the opposite does not happen.

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