European Journal of Scientific Research

ISSN 1450-216X Vol.41 No.2 (2010), pp.314-322

© EuroJournals Publishing, Inc. 2010
http://www.eurojournals.com/ejsr.htm

Impact of Money Supply on Current Account: Extent of

Pakistan

Sulaiman D. Mohammad
Department of Economics, Federal Urdu University, Karachi
E-mail: Sulaiman1959@gmail.com

Abstract

The purpose of this research is to find out the empirical association among money
supply, current account, exchange rate, and industrial production, for this purpose we have
used (Johansen, 1988) co integration technique to analyze the long run relationship and
Error Correction model to estimate the short run dynamics by using annual data for the
period of 1975 to 2008. The domestic variables support long run relationship and weak
relation in short run. Fragile combination of fiscal and monetary policy, finding supports J-
curve theory and expenditures switching affect theory.

Keywords: Money supply, Current Account, Co-integration

JEL Classification Codes: C5, E5, F4

1. Introduction
Economic management, stabilization and adjustment of any developing country are totally concern
with the main instruments of an economy, monetary policy and foreign exchange rate. In most of
developing economies real exchange rate shows the international competitiveness and high inflation as
a result of currency devaluation and expansionary monetary policy.
Monetary policy refers to implementations of central bank or monetary authorities that focusing
on supply and availability of money regarding to reduce unemployment and control inflation.
Keynesian economists argue expansionary monetary policy lead to economic growth, Monetarists
explain ideal condition for maintaining inflation and steady growth is constant or slow increase of
money supply.
There are many types of monetary policies which focus on inflation, exchange rate and money
supply. Monetarists believe in money supply targeting policy. In exchange rate targeting policy
authorities adopt pegged exchange rate and some time devalue local currency in case of developing
countries, exchange rate targeting policies lead to increase black economy. In inflation targeting or
price level targeting policies central bank adjust interest rate according to economic condition. Interest
rate plays a key role towards maintaining output gap and inflation (John B. Tylor). Some European and
Asian countries, as well as Pakistan is also practicing inflation targeting policies. In case of our country
both policies inflation targeting and exchange rate targeting polices simultaneously practiced but these
policies did not show significant impact. What were the main reasons, economists argued that there is
no coordination between fiscal and monetary policies. The statistical facts of money supply for last few
decades mentioned in appendix.
A wide ranging empirical literature has documented deferred and constant effects of monetary
policy shocks on output. Theoretically real interest rate, inflation and the industrial production are the
Impact of Money Supply on Current Account: Extent of Pakistan 315

result of money supply, expansionary policy leads to depreciate currency and current account deficit in
short run while, contractionary monetary shock leads to current account surplus in short run (Jaewoo
Lee).
Many economists have examined that fluctuation in the central fund rates are a significant
proxy for changes in monetary policy. Central fund rate have significant impact on macroeconomic
aggregates but after 1980 it has been seen good measure of monetary policy but its impact on
macroeconomic aggregates are not considerable (Nathan S. Balke & Kenneth M. Emery).
(Michael B. Devereux and Hans Genberg) examined by using open macro economic model in
the case of China, expansionary monetary policy leads to increase in the real output and permanent
price level for the time being, some countries have been selected like Hong Kong and Philippines. It is
found an international imbalance have high significant correlation with China exchange rate
appreciation. This study shows the positive domestic effect on international economies. Moreover,
results emphasize the rising significance of China for its adjacent economies (Tomasz J. Kozluk &
Aaron N. Mehrotra ).
(Lu & Min) analyzed a two sectors in a small open economy. Applying general equilibrium
approach of expectation they examined current account sensitivity to monetary policy shocks depend
on the elasticity of substitution among investment, consumption and risk aversion and in case of a
small open economy, current account efficiently react to technological shocks. In case of France, Italy,
UK, the monetary policy shocks impact on balance of trade as a result with Expenditure-switching
effect and also found a little support J-curve effect (Soyoung Kim).
Money supply can be defined in Pakistan that the financial assets are highly liquid among other
variables. M2 money supply variable is usually considered as proxy of money supply in most of the
cases and it has a closed substitution of liquid asset as well as show the financial assets have used as
medium of exchange ( Mahmood-ul-Hasan Khan & Fida Hussain).
J-curve theory explains the sensitivity of trade variables import and export due to devaluation
or depreciation of currency. at first the depreciation in currency leads to deficit in current account and
expansive import, but later on access in international market having ease competing with foreign
producers cause reduce cost after some period, consequently the volume of export and price of imports
increased cause to reduce the current account deficit. Inverted J-curve shows currency again get back
to the appreciation.
This research shows that the empirical evidence of money supply on current account variables
such as import, export, net factor payment and real interest rate, exchange rate, inflation and industrial
production. Impact of money supply on economy is sizzling issue of existing scenario, some fruit full
detail of money supply in Pakistan find in appendix of this article.
Section 1 provide introduction and literature review section 2 an 3 shows data source
methodology section 4 and 5 provide result of study and recommendations.

2. Data Source Model Specification

We have used time series data from 1975 to 2008. Data has taken from State bank of Pakistan’s web
site, World bank data site (WDI) and International finance statistic (IFS) site. Given variables defined
as; R denotes short term real interest rate, M denotes monetary aggregate M2, CPI denotes consumer
price index, IP denotes industrial production, XR denotes real exchange rate NFP denotes the net factor
payment, EX denotes Export and IM denotes proxy of Import. The model of our study is
M= β0+ β1EX + β2IM + β3R+ β4CPI+ β5IP+ β6XR+ β7NFP+€
316 Sulaiman D. Mohammad

3. Econometrics Methodology
In multivariate model case, Johansen co integration technique is used to find association between the
variables. This study consists six variables therefore, Engle Granger technique is not applicable
because it is used for bivariate model.
Generally, empirically evidences confirm that numbers of the macro variables are non-
stationary series with traditional approach of ordinary least square (OLS) give the possibility of
spurious regression. The non stationary in the variable can be removed by differencing the time series
variable. Further objects the similar on the position that such a method involves failure of potential
long run information of the data. In this situation, co integration and Error correction techniques hold
long run information has been recommended. Co integration method deals with spurious regression
and Error correction reflects short run dynamics and attempts to positive causal association. A series
that is stationary are differencing “d” and denoted as I (d). Augmented Dickey Fuller Test also
identified as unit root test are employed for testing the stationary and non stationary of the series. ADF
testing the subsequent regression equation:
ΔYt = α + β Yt −1 + t + ∑ β 2 ΔYt − k + μ t
Where Yt stands for a time series, Δ stands for a first difference, T stands for a linear trend, α
stands for a constant and μ is an error term. The null hypothesis of unit root is 0 = β. If any variable is
known to be non stationary it may be tested for stationarity at first difference. If any variable is found
stationary at first difference then bivariate co integration test will be implied to recognize the
association between variables.
In this study Johansen test (1988) method is employed for co integration because of
multivariate model. This co integration technique is employed to find out the number of co integration
vector (Kerry Patterson). If any variable is co integrated, it reflects that there must be existence of an
error correction in series which represent as:
ΔM = α + β 1 ΔEX + β 2 ΔIM + β 3 ΔR + β 4 ΔCPI + β 5 ΔIP + β 6 ΔXR + β 7 ΔNFP + β 8 μ t −1 + ε
Where the error correction term is stationary residual form co integration equation. ECM
reflects the β 8 μ t −1 coefficient’s significance whether it is to be negative or positive which reflects the
short run dynamics of the model.

4. Result Analysis
Recent advancement in the field of econometrics refers that number of macroeconomics variables
series are non-stationary. This influence described such regression is spurious and unpredictable to
forecast, if the variables are not found stationary or integrated at different orders. Thus it is essential to
verify stationarity of the variables of time series data prior to evaluating the long run association
between variables.

Table 1: Unit root test ADF (Augmented Ducky Fuller)

Variables Level with intercept and trend (lag length) First Difference with intercept and trend (lag length)
Import 1.90522(0) 6.805222(1)
Export 1.30590 (0) 6.579430 (1)
R 2.565322 (0) 5.422587 (0)
CPI 3.212361 (1) 4.646054 (5)
IP 3.159647 (3) 4.366135 (5)
XR 1.754631 (1) 7.389702 (0)
NFP 2.32541(3) 4.23000(1)
M 1.95214(3) 5.32511(1)
Impact of Money Supply on Current Account: Extent of Pakistan 317

The table-1 shows the result of unit root test found from using the Augmented Dickey Fuller
(ADF) test. This test has been evaluating the stationarity in the variables with trend and intercept.
After evaluated the stationarity at level, our result reflects that there is non stationarity in the
data series therefore, we test out the stationarity at first difference, and hence our result exhibits that all
the variables are stationary at first difference, now ADF equation is employed again with trend and
intercept. The brackets values exhibit the lag length of difference variables and all variables are
integrated at first order i.e. is I (1).
After evaluated the stationarity between the variables, result postulates that the data is
integrated at second order and our next step to verify the long run association between variables
whether it is exist or not, for this purpose the Johansen co integration test has been used and its
findings in table-2 and table-3 as:

Table 2: Johensen Co integration test (trace value)

Null Hypothesis Alternative Hypothesis Maximum trace statistics 5% critical value P-Value
r=0 r=1 240.5128* 125.6154 0.0000
r=1 r=2 157.2804* 95.75366 0.0000
r=2 r=3 97.22221* 69.81889 0.0001
r=3 r=4 57.29995* 47.85613 0.0051
r=4 r=5 27.08921 29.79707 0.0995
r=5 r=6 8.609252 15.49471 0.4028

Table 3: Johensen Co integration test (Eigen value)

Null Hypothesis Alternative Hypothesis Maximum Eigne Value 5% critical value probability
r=0 r>1 83.23238* 46.23142 0.0000
r=1 r>2 60.05818* 40.07757 0.0001
r=2 r>3 39.92226* 33.87687 0.0084
r=3 r>4 30.21074* 27.58434 0.0225
r=4 r>5 18.47996 21.13162 0.1129
r=5 r>6 7.523857 14.26460 0.4292

Table no. 2 and 3 shows the result of co integration test. The Johansen- Juselius co integration
test illustrates that all these seven variables are co integrated of six vector as we saw in the given table-
2 and table-3, both maximum trace statistics and maximum eignen values reflect r=6 co integration
equation. Optimal lag of VAR model is 2-lag by using Shewariz criterion therefore, the result shows
six co integration equations in the VAR model postulates the long run association between variables.
The subsequent table-4 exhibits the result of Error Correction Model equation as above given.
The ECM is used to analysis the spurious correlation in the short run dynamic association among
output, financial structure, physical and capital formation, and financial development. The long run
dynamics show in the set of regression equations. Technically, Error Correction Technique calculates
the pace of adjustment get back to Co-integrated associations. The ECM estimates a force influencing
the integrated variables to go back their long-run relation when they deviate from the deviation
(Banerjee, et al, 1994). An equation of error correction model as:
ΔM = α + β 1 ΔEX + β 2 ΔIM + β 3 ΔR + β 4 ΔCPI + β 5 ΔIP + β 6 ΔXR + β 7 ΔNFP + β 8 μ t −1 + ε
318 Sulaiman D. Mohammad
Table 4: Error Correction Method Result

Variables T-Value P-Value

D(Exp) -2.2 0.02
D(Imp) 2.8 0.06
D(R) 1.9 0.08
D(CPI) 2.1 0.09
D(IP) 2.3 0.01
D(XR) 1.85 0.08
D(NFP) -2.6 0.05
UT(-1) -0.3 0.06

The estimated lagged ECM [error correction term], UT(-1) is negative and highly significant.
This result supports the co integration between the variables exhibited in table-3. The feedback
coefficient is –0.3, which advocates a normal adjustment process. Almost 30% of the disequilibria of
the earlier year’s shock adjust back to the long run equilibrium association in the present year.

5. Conclusion & Implication:

This research evaluated the effects of money supply on current account using a Johnson’s co
integration approach for the economy of Pakistan from the period 1975 to 2008. Our model has
exhibited a number of important findings which confirm the impact of monetary policy shocks on
current account is dependable on expenditure switching effect, and our results also reflect the little
evidence of J-curve impact. Our co-integration and ECM findings also support the theoretical analysis.
Our main finding is that the monetary policy system has an important influence on the domestic
variables (for instance, output and inflation), but has less influence on external variables such as
current account and real exchange rates. In policy rules we have examined that the policy rules seem to
work best overall therefore, central bank should target the domestic (producer) inflation. The central
bank ought to focus to manage the impact of the currency depreciation on import price inflation rather
than adjusting interest rates which help to keep stable producer prices. Our finding also suggests
applying pegged exchange rate system due to the high valued currencies are not only lead to volatile
inflation but also slow down economic growth.

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Appendix
Time Deposits & M2 as % of Total Deposit & GNP (1970-2007)
Impact of Money Supply on Current Account: Extent of Pakistan 321

In case of Pakistan the central bank uses these major tools of monetary policy: credit to
commercial banks, interest rate channels , margin requirement and cash reserve ratios.
322 Sulaiman D. Mohammad

Growth Rates of Monetary Variables (%)

Where
gM1: Represent the Growth Rate of Money Supply (M1)
gM2: Represent the Growth Rate of Broad Money Supply (M2)
gRM: Represent the Growth Rate of Reserve Money.