The Causal Relationship between Money Supply, Inflation, and Industrial Production in India: Vector Error Correction Estimation

Abstract

Both Keynesians and monetarists believe that inflation is caused by an increase in aggregate demand, which is caused by an increase in the money supply. The most significant impact of inflation is to distort relative prices, and savings, investment, and the fiscal balance. Though inflation is generally associated negatively with economic growth, there may also possibly be a threshold or positive effect of price rise on industrial growth, and thereby, on the economy. This paper examines the long- and short-run causal relationship between infl ation, money supply, and industrial output in India over the period 1981 to 2020, applying the vector error correction mechanism (VECM) approach. The unit root tests show that the index of industrial production, reserve money, and consumer price index are stationary at the second difference, and the Johansen cointegration test reveals that the variables are cointegrated. The coefficient of the error correction term in the VECM estimates is negative, significantly in the infl ation equation, and insignificantly in the output and money supply equations. The VECM results reveal short-run causality between money supply and industrial production, showing disequilibrium in the short-run relationship between industrial production, inflation, and money supply, and quick adjustment towards the long-run equilibrium. The speed of adjustment in the inflation equation is 24 per cent. Therefore, about 24 per cent of the short-run deviation, i.e. disequilibrium, in the inflation-growth relationship is adjusted every year.

Keywords: Industrial Production, Money Supply, Infl ation, Causality, VECM Estimation

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