Assignment

Topic: Effect of broad money supply on economic growth in

Bangladesh
Monetary Economics
Course no: 316

Submitted to:
Abul Kalam Azad
Assistant Professor
Department of Economics
University of Dhaka

Submitted by:
Nazifa Mussarrat
Farhana Akther
Imtiaz Amin Chy
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 Abstract:
The extent of economic growth of a country is measured using Gross Domestic product, GDP.
Money supply is the entire stock of monetary assets available in a country at a definite period of
time. Usually the currency in circulation and demand deposits are the components of money
supply. This study explores the relation between GDP and Money supply using time-series data
for a period in between 1994-2017 for Bangladesh. The Vector Error Correction Model has been
implemented to look into and measure the magnitude of the said relationship. As control variables,
Gross Capital Formation and the total value of imports of goods and services have been used. This
study finds that money supply has a positive impact on GDP.

 Introduction:

Macroeconomic policy modeling, for all its intents and purposes, aims to achieve output growth.
An important portion of policy modeling involves the study of functional relations in between the
variables that directly or indirectly influence the variables under scrutiny. This paper seeks to look
into the relation between economic growth and money supply and find an approximate measure of
the magnitude of the said relation.

Gross Domestic Product (GDP) is a popular measure of the extent of the growth of an economy.
As the broadest measure of a nation's total economic activity, GDP measures the total monetary
value of all goods and services produced within the territorial boundary of a country within a
specified period of time. The components of GDP include personal consumption, government
expenditures, investment and net exports. The value of GDP mirrors the total economic output for
a country for a given year. The GDP growth rate in Bangladesh has averaged around 5.6% from
1994 to 2016 with the record low being in 1994 at 4.08% and the highest at 7.11% in 2016.

The money supply is a component of the money market, and the money market is where money is
traded as a commodity. It consists of the total value of all monetary assets available in an economy,
which includes the currency in circulation and the deposits made to the financial institutions.
Money supply has indirect affects on output through interest rates. An increase in money supply
drives down the interest rate which helps to boost investment. There are two main school of
thoughts on the matter of money supply- the Monetarists and the Keynesians. While the
Monetarists think money supply as a factor that augments output, Keynesians are of the opinion
that money supply has very little to do with output.

Money supply and output have been at the front and center of the discussion of monetary
economics for some time. Understanding the working interlinkage in between money supply and
GDP growth is imperative in executing proper macroeconomic policies. (Mckinnon, 1973), (Shaw,
1973 ), (Fry, 1997) have deliberated about the importance of the relation between money supply
and GDP in their literary and quantitative works.

The economy functions through a deep interlinkage between money supply and economic growth,
with the two being interdependent on one another. A growth in money supply is seen as to be a
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positive factor for economic growth, because as money supply rises there is a fall in interest rates
which leads to increased consumption and higher borrowing. However, this is not always the case
with conflicts occurring in the long run. GDP growth also has effects on money supply, although
this effect is negative because an increase in GDP would mean that the value of money would
increase, allowing it to be traded for a greater bundle of goods and services.

 Literature review:

The objective of this paper is to probe into the relation between broad money supply and economic
growth and determine the nature of the said relationship. In this connection, selected works from
researchers around the world have been assessed and brought into context with our objective.

(Sims, 1972): Conducted an investigation into the money supply and output of the United States.
The study revealed that there exists a causal inter-link between money supply and GDP i.e. money
supply helps interpret output.

(Chude & Chude, 2016): Examined the ties between broad money supply M2 and economic
growth in the context of Nigeria. Using broad money, inflation rate, interest rate, monetary policy
rate as explanatory variable, the effects on the explained variable rate of growth of GDP was
investigated using ordinary least square method for a period from 1987 to 2010. The tests reveal a
positive relation between broad money and economic growth.

(Maitra, January,2011): Conducted a study to test the co-integration of money supply with output
in Singapore for a period from 1971-72 to 2007-08. The author used the M1 component of money
supply and decomposed it into an anticipated and an unanticipated part. Mathematical relations
and tests revealed that the unanticipated component of money supply positively and considerably
affected output levels. Although the author did remark that output growth was not proportional to
changes in money supply.

(Huat & Wai, April,2000 ):Found a promising relation between both narrow and broad aggregates
of money supply and GDP while examining data for Singapore during a period from 1975-1998.

(Aslam, 2016) : Investigated into the effects of money supply on the Srilankan economy. Using
money supply, exchange rate, import outflow, Colombo consumer index, exports earning as
independent variable, tests were conducted to examine the effects on the dependent variable GDP
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utilizing time series data from 1959-2013. Results revealed that money supply indeed had a
positive and significant impact on the economic growth of Srilanka.

(Lee & Li, 1983): Looked into the causal relation between money, income and prices in Singapore.
The authors concluded the existence of unidirectional causal relation between money and price
and the existence of a bidirectional causal relation between income and money.

Although the previously reviewed studies conclude with the existence of a positive
relation between broad money supply and economic growth, there are instances of studies that
dispute the positive relation and suggest instead that there exists a negative relation between broad
money supply and economic growth. These are discussed as follows:

(Lashkary & Kashani, 2011): Examined the relation between broad money supply and economic
growth using time series data 1959-2008 of Iran. The authors estimated the effects of money
growth on real economic variables employment and growth rate. The authors closed on the result
that money growth did not affect employment and economic growth.

(Morris & Becketti, 1992): Explored the capacity of money to predict economic activity in the
future. Firstly, the authors raised the question of money's relation to economic activity where they
discussed the effects of money demand and supply on output through the fluctuation of interest
rate. Secondly, the authors conducted an elaborate discussion on why the relation between money
and economic activity may have changed. The authors highlighted that the deregulation of the
financial markets in the 1980s resulted in a change in the way money demand and supply were
affected. Money demand shifts were said to have an effect on interest rate and consequently output.
But the changes in operating procedures were temporary and later on emphasis was put on short-
term interest rates again. The authors finally inferred that the deregulations in the 1980s could have
reshaped the way money affected the output. Researches where the data from the 1980s were
included found a decline in the capability of money to predict future economic activity whereas
the researches that did not include data from that period found that the power of money to predict
future economic activity remained unmitigated.

(Ehigiamusoe, 2013): Looked into the influence that the money market possessed over economic
growth. In this connection, the authors resorted to data from the period 1980-2012 from Nigeria
using econometric methods like OLS, Vector correction model, Johanson's co-integration test to
examine both long and short run relations. The authors concluded that there did exist a long run
relation between the money market and economic growth but due to certain challenges present in
the Nigerian economy, the money market, presently, does not possess much influence over
economic growth.
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(M.Gatawa, Abdulgafar, & Olarinde, May - June 2017): Carried out an empirical study with an
aim to examine the effects of interest rate, money supply and inflation on economic growth. In this
context, time-series data from 1973-2013 from Nigeria was utilized. VAR model and Granger
Causality test within error framework were employed. The results of the VEC model revealed that
broad money supply had a positive impact on economic growth whereas inflation and interest rates
retarded growth mostly in the long run. But, in the short-run, broad money supply and interest rate
negatively affected economic growth.

(Adusei, 2013): Experimented on the impacts of financial developments on economic growth.

Using time series data 1971-2010 for Ghana, the authors employed fully modified least square
method, generalized method of moments and Error correction to find the aforementioned relation.
Financial development was measured using broad money supply as a share of GDP, domestic
credit as a share of GDP, domestic credit to private sector as a share of GDP. The authors came to
the conclusion that broad money supply hampered economic growth in the short as well as the
long run.

(Loayza & Ranciere, 2005): Examined a sample consisting of annual data from of countries from
1960-2000. Tests revealed that in the long-run there exists a positive as well as significant link
between financial intermediation and economic growth. However, the relation was found to be
negative in the short-run. The authors remarked that the relation between economic growth and
financial intermediation depended on whether the step was perpetual or interim

 Methodology:

Annual time series data for the period in between 1994-2017 for Bangladesh has been utilized
for the purpose of this investigation. The datasets were collected from World Development
Indicators (WDI) of the World Bank.

Vector Error Correction Model has been used in the present study. The Augmented Dickey
Fuller(ADF) test examines the dataset for the presence of unit root and the Phillips-Perron test
looks into the degree of integration among the variables. Two variables are thought to be co-
integrated if they have a long term relationship between them.
As a proxy variable for economic growth, Gross Domestic Product has been used. Using Gross
Domestic product as the dependent variable, tests were performed using Money supply, Gross
Capital Formation and Total value of imports of goods and services as the independent variables.
The function is as follows:

GDP=f(MS, CAPFOR, IMPORTS)

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Utilizing double log model, the econometric model has been formulated as follows:

lnGDP=Constant+lnMS+lnCAPFOR+lnIMPORTS+error term

where,
GDP=Gross Domestic Product
MS=Money Supply
CAPFOR=Gross Capital Formation
IMPORTS= Total value of imports of goods and services
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 Findings:
Dependent Variable: GDP
Constant: -4.535717
Regressors Coefficient P-value
lnMS 0.1100956 0.00
lnIMPORTS -0.0900514 0.00
lnCAPFOR -0.906582 0.00

Economic growth, GDP= (-4.535717) + (0.1100956) Money supply + (- 0.0900514) IMPORTS

+ (-0.906582) CAPFOR

In this model, GDP was used as a proxy variable to capture economic growth. The model shows
that, if there is no effects of money supply, imports and capital formation, the value of GDP will
be (-4.535717)

 The value of the coefficient of money supply is 0.110956 which indicates that holding other
factors constant, with 1% increase in money supply, GDP goes up by 0.11% approximately.
 The value of the coefficient of imports is (-0.0900514) which indicates that holding other factors
constant, with 1% increase in imports, GDP falls by 0.09% approximately.
 The value of the coefficient of capital formation is (-0.906582) which indicates that holding other
factors constant, with 1% increase in capital formation, GDP decreases by 0.9% approximately.
 In case of the effects of money supply on GDP, we reject null hypothesis (H0: coefficient of
money supply=0) as P value is 0, it is the test is statistically significant that’s why we reject null
hypothesis.
 In case of the effects of imports on GDP, we reject null hypothesis (H0:coefficient of imports=0)
as P value is 0, the test is statistically significant enabling us to reject null hypothesis.
 In case of the effects of capital formation on GDP, we reject null hypothesis (H0:coefficient of
capital formation=0) as the P value is 0,the test is statistically significant enabling us to reject
null hypothesis.
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2.50E+13
Relation between GDP and Money supply
2.00E+13

1.50E+13

1.00E+13

5.00E+12

0.00E+00

GDP Money Supply

As seen from the diagram, GDP and broad money supply share a similar upward trend.
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 Conclusion:

The present study looked into the dynamic influence that money supply holds on economic growth
as measured by GDP. Using Vector Error Correction model and utilizing data for a period from
1994-2017 for Bangladesh, we have been able to draw the conclusion that money supply positively
affects economic growth.
The implications of this study lies in its application in macroeconomic policy formulation. The
study has been able to show a positive relation between money supply and growth, a negative
relation between the imports of goods and services and economic growth and a negative relation
between capital formation and economic growth. The linkage between capital formation and
economic growth cannot be dealt with the typical methods of short-run equilibrium (Capital
Formation and Economic Growth, 1955). Policy-makers can take into account the positive
relation and adjust policy instruments accordingly. They will also need to pay heed to the negative
impact that imports hold over economic growth and devise policies accordingly. Capital formation
is important in sustaining the growth of an economy and measures must be taken to promote
savings as well as investment.

This paper is limited in its capabilities and accuracy to the precision and validity of the datasets
collected. Also, this paper looks only into the case of Bangladesh for a very short-period of time.
Political, social and international factors come into play which affect the path in which the
economy moves. Considering these factors held constant, we can deduce on the basis of empirical
evidence that money supply positively affects economic growth.
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 Appendix:

The results table as retrieved from Stata :

 Reference:

1)https://databank.worldbank.org/data/reports.aspx?source=world-development-indicators
2) https://www.researchgate.net/
3) https://www.wikipedia.org/
4) https://www.jstor.org/
5) https://www.nber.org
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