Journal of Social and Organizational Analysis, 2015 Devaluation and Its Impact on Money Supply Growth Muhammad Asif * Management Sciences Department, COMSATS Institute of Information Technology Abbottabad, Pakistan m_asif@ciit.net.pk, Syed Qasim Shah PhD Scholar, Department of Finance and Banking, Faculty of Business and Accountancy, University of Malaya, Malaysia Abstract Economic activities are concerned with exchange rate appreciation or depreciation. It is observed that money supply growth depends on exchange rate changes and vice versa. Thus, the objective of current study was to investigate the long run and short run effect of currency devaluation on money supply growth. The data set include annual observations for the period 1973-2014. The empirical results revealed that currency devaluation has a significant positive relationship with money supply growth in long run, as well as in short run. Both in the long and short run, money supply growth were affected by currency devaluation. Keywords: Devaluation, Money Supply, Co-integration, Error Correction Mechanism JEL Classification: C22, E51 Introduction The most common schools of thought that built the foundations for devaluation are elasticity approach, monetary approach and absorption approach (Jimoh, 2004). According to Bahmani-Oskooee (2002), researchers have a debate to find arguments for and against the devaluation. Despite this debate, it is a fact that devaluation has ability to effect trade balance, money supply and output growth, as the devaluation lowers the exports prices and raises the prices of imports (Bahmani- Oskooee, 2002). Most of the economists favored the currency devaluation and considered it an effective component of the economy (Brahmasrene and Jiranyakul, 2002). According to Bahmani-Oskooee (2007), the devaluation of exchange rate increases the prices of imported goods, which follow the reduction of aggregate supply. The Kalyoncu et al. (2008) also has the similar views that devaluation raises the domestic interest rate, which leads to decrease in aggregate supply. This study was initiated to investigate the relationship between currency devaluation and money supply growth while keeping other things constant because it is general observed that the changes in money supply are the outcome of currency devaluation or depreciation in the economy. In this paper, the section 2 is comprised of literature review, section 3 describing methodology and data sources, section 4 was concerned with data analysis and discussion and section 5 conclude the article. Empirical Evidences The empirical evidences regarding the relationships among exchange rate depreciation or devaluation, a number of researchers have investigated output growth and money supply growth. Bahmani-Oskooee et al. (2002) has explored a contractionary effect between exchange rate depreciation and output growth. Christopoluos (2004) investigated that the currency depreciation exerts a 60 *Corresponding Author
Journal of Social and Organizational Analysis, 2015 negative impact on output growth. Upadhyaya et al. (2004) investigated the effect of currency depreciation using panel data and found that exchange rate depreciation has expansionary impact in the short run while it has a neutral impact in the end. Asif (2010) explored that exchange rate has a cointegrated relationship with trade balance in Pakistan. He used Autoregressive Distributed Lag (ARDL) approach to cointegration over the period 1973 to 2010. Thanh and Kalirajan (2006) find that there has been two-way causality between money supply growth and inflation; exchange rate and inflation; and money supply growth and exchange rate in Vietnam in 1990s. Both the long and short run results suggested that devaluation could be implemented to encourage exports, to improve current account balance and BOP, and to reduce the real exchange rate appreciation in the short run. The monetarist approach to exchange rate determination is based on the argument that devaluation reduces the real value of cash balances (Ali et al., 2014) and/or changes the relative price of traded and non-traded goods, thus improving both the trade balance and the balance of payments (Mills, 1979). A significant implication of monetary approach is that devaluation can improve balance of payments only in short run (Krugman and Obstfeld, 2000). The effects of devaluation in the end are quite uncertain. As devaluation of domestic currency is made in short run, it encourages exports and discourages imports by increasing competitiveness of the economy. With the increase in exports and decrease in imports after a time period trade surplus emerges which leads to the increase in foreign exchange reserves (Auer, 2015: Ogundipe et al., 2013). As a result, over time money stock in the domestic economy increases causing increase in the aggregate demand and in price level. The higher aggregate demand and price level bring back the economy into full employment equilibrium and external balance (Ahuja, 2007). Ahuja (2007) further stated that in monetary approach to balance of payments under flexible exchange rate regime, it is assumed that capital is perfectly mobile between countries, while under the fixed exchange rate, the balance of payments equation is used to predict how foreign exchange reserves will change. In case of flexible exchange rate regime, the balance of payments equation is used to predict the changes in exchange rate (Kilic, 2016). Data and Methodology The purpose of this study is to find the relationship between the currency devaluation and money supply growth. For this purpose, the annual data regarding exchange rate and money supply growth was extracted from State Bank of Pakistan ranging from 1973 to 2014. The study employed the log linear model for estimating the results. The econometric form of the model is as follows: log( M 2) log( RER) ------------- (1) 1 2 Where, M2 represents money supply growth in Pak Rs. Million and RER represents real exchange rate. The econometric procedure adopted for analysis of important results for this study is as follows: Firstly, to examine whether a time series have a unit root, an Augmented Dickey-Fuller (ADF) unit root test has been applied. Secondly, finding the long run relationship among the variables especially when there are two variables only option available to use Engle and Granger test for cointegration. The next step is to perform Error Correction Model for short run analysis if the variables are cointegrated. To check the direction of relationship between currency devaluation and money supply growth Granger- Causality was also employed. 61
Volume-1, Issue-2 Empirical Results and Discussion It is often observed that the time-series data exhibits a non-stationary trend. Therefore it is suggested to check the non-stationarity using Augmented Dickey Fuller (ADF) test. Dealing with non-stationary data leads to spurious and nonsense regression results. To check the stationarity of money supply and real exchange rate variables, ADF test was applied. The results are shown in Table 1. Table 1 Augmented Dickey Fuller (ADF) Test Variable Level First Difference Decision M2-2.733 (-4.226)[1] -4.725 (-4.252)[2] I (1) RER -1.306 (-4.226)[1] -6.052 (-4.234)[1] I (1) Note: MacKinnon (1996) critical values. The lag length are selected based on SIC criteria. It is obvious from the results that variables are stationary at first difference. The next step is to perform cointegration among the variables. By applying cointegration test we can observed that weather there exist a long-term relationship or not. Results of regression analysis are presented in Table 2. It is found that real exchange rate has a positive and significant effect on money supply growth. A one percent increases in real exchange rate lead to leads to money supply growth by almost 1.89 percent. The diagnostic statistics confirmed that the model is free from biasness. The goodness of fit of model that is obvious from R-square value that is the variation explained in money supply growth due to real exchange rate is about 90 percent. The overall significance of the model is confirmed from F-statistics i.e. 368.58. Table 2 Empirical Results of the Model Dependent Variable: Log [M2] Constant 6.79 (0.000)* Log (RER) 1.89 (0.000)* R-squire 0.911 Adjusted R-squire 0.90 F-Statistics 368.58 Probability (F-Statistics) 0.0000* Note: Values in parentheses show p-statistics. The statistics significant at 1, 5 and 10 % level of significance are indicated by *, ** and ***. Serial Correlation LM Test = 2.27[0.0047]; ARCH test = 1.1407[0.2928]. Ramsay Reset Test = 3.757 [0.060] The result of ADF test for residual revealed that the residual is stationary at level as ADF value is -3.345, which is less than the critical value that is -3.204 at 10% level of significance. This result authenticates that money supply and exchange rate have long run relationship between them. Once a long-term relationship is confirmed, the next step is to perform error correction model (ECM). ECM also confirms the existence of long-term stability among the variables. The results of ECM are presented in Table 3 below. 62
Table 3 Empirical Findings of Error Correction Model Dependent Variable: DLog (M2] Constant 0.0671 (0.4413)* DLog (RER) 0.414(0.6361)* p -0.226 (0.0000)** R-squire 0.034 Adjusted R-square -0.022 F-Statistics 0.6068 Probability (F-Statistics) 0.5508** Journal of Social and Organizational Analysis, 2015 Note: Values in parentheses show t-statistics. The statistics significant at 1, 5 and 10 % level of significance are indicated by *, ** and ***. The result of Table 3 is important in explaining the short-run impact of exchange rate on money supply growth and long-run adjustment of exchange rate and money supply. The results indicate that there is one percent increases in real exchange rate, 0.414 percent change will occur in money supply. The coefficient of long-term convergence reveals that 22.6% of the disequilibrium in money supply is adjusted each year when exchange rate is the explanatory variable. Conclusion The aim of this article was to explore the relationship between currency devaluation and money supply growth in Pakistan. To achieve the objective, study employed unit root test and Engel and Granger approach to cointegration. The secondary data ranging from 1973 to 2014 was extracted from State Bank of Pakistan. The study reveals that there is a significant positive relationship between devaluation and money supply growth in long as well as short run. Both the long and short run results suggested that devaluation could be implemented to give confidence to money supply growth. Since, a greater number of the disequilibrium in money supply is adjusted through the real exchange rate every year, so it needs to be a special attention in the short run. References: Ahuja H. L (2007). Macroeconomics Theory and Policy: Advanced Analysis, New Delhi, India, S Chand & Company Ltd. Ali, D. A., Johari, F. and Alias, M, H. (2014). The Effect of Exchange Rate Movements on Trade Balance: A Chronological Theoretical Review. Economics Research International, doi:10.1155/2014/893170 Asif, M and Rashid, K. (2010). Time Series Analysis of Real Effective Exchange Rates on Trade Balance in Pakistan, Journal of Yasar University, 5(18), 3038-3044 Asif, M., Shah, S. Q., Zaman, K. and Rashid, K. (2011), Devaluation and Output Growth: Evidence from Pakistan. Mediterranean Journal of Social Sciences, 2(2), 394-401. Auer. R. A. (2015). Exchange Rate Pass-Through, Domestic Competition, and Inflation: Evidence from the 2005-08 Revaluation of the Renminbi. Journal of Money, Credit and Banking. 47. 1617-1650. 63
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