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Estimating the role of money supply in determining aggregate investment in Pakistan

  • 2018 | Volume: 2 | Issue: 1 | Page: 75-90


This study investigates the role of money supply in determining the Pakistan's aggregate investment for the period 1980-2015. Hodric-Prescott Filter method has been applied for extracting the trend from the data. For estimating the results ordinary least squares method, granger causality test and Vector Autoregression has been used. The results revealed that money supply (M1 and M2) increases the aggregate investment in Pakistan. Other variables such as GDP growth rate and saving also showed a positive and significant association with aggregate investment. However, foreign direct investment remained insignificant. These findings recommended that the State Bank of Pakistan can used both M1 and M2 as an effective instrument of monetary policy for increasing the level of aggregate investment component of aggregate demand in the economy.

Keywords and JEL Classification


Money Supply, Aggregate Investment, Granger Causality test

JEL Classification

E51, E52, E12

1. Introduction

   Money supply is the total stock of money available in country at a specific time period. The central bank of a country usually adopts different tools i.e. open-market operations, reserve requirements and discount rate to control money supply in the country. The fluctuations in level of money stock in an economy have important implications for the performance of most of the macroeconomic indicators. On one side money supply expansion can put inflationary effects on an economy. While, on the other hand money supply increase may also affect the economic growth of a country positively. Moreover, money supply as a determinant of aggregate demand plays a crucial role in the formulation and successful implantation of monetary policy for the stabilization of business cycles. During a period of recession, central banks use expansionary monetary policies. In contrast, when the economy is in the expansion phase of business cycles, then the government can decrease the money supply for controlling inflation.

   The monetary policy works through different transmission channels in an economy. Some of the channels are the interest rate channel, exchange rate channel, asset price channel, banking lending channel and balance sheet channel (Lucky & Kingsley (2017). Through these channels the central bank’s monetary policy decisions affecting consumption and investment levels, employment and ultimately price level etc. (Mishkin, 1996).

   It is a fact that all of these monetary transmission channels are having both positive and negative effects on all the major macroeconomic variables in an economy. However, the empirical results about all of these channels are still inconclusive. Therefore, it is important to explore the effect of monetary policy on different components of aggregate demand for a more detail understanding about its role in the economy (Khundrakpam, 2012; Nasko, 2016; Obadeyi et al, 2016). The different components of aggregate demand consist of aggregate consumption, aggregate investment, government expenditure and net exports. However, the fluctuations in all of these components of aggregate demand can result in a significant upward and downward shift in the output level in an economy. The aim of the present study is to investigate the impact money supply on aggregate investment in Pakistan.

2. Literature Review

   Gramm and Nash (1971) investigated that change in the stock of money can affect income of agriculture sector and investment in United States. Data were collected from 1919-1966 and the results showed the existence of a relationship between money stock and investment and income of agriculture sector. Gertler and Grinols (1982) also found that money supply affected investment. They also found that the investment depended on the capital holders demand for assets. Growth in money supply also affect inflation level and thus demand for capital also changed. However, they reported that money supply growth decreased the investment.

   Gaiotti and Generale (2002) investigated the impact of monetary policy on behavior of investment and concluded that the role of money supply was an important determinant of the investment. Majeed and Khan (2008) investigated the determinants of private’s investment in Pakistan utilizing a broader time period of 1970 to 2006. Augmented dickey fuller test was used to identify the trend in data and then ordinary least square technique was used for regression. The results indicated that private production, net inflows and past stocks are the main determinants of private investment. Ang (2010) investigated the key factors of investment in Malaysia, using bank credit for investment as a one of the explanatory variables. Using the time series data from 1960-2005 and applying the autoregressive distributed lag (ARDL) and the error correction model (ECM), found that there was a positive effect of monetary assets in economy on investment. Furthermore, insecurity of macroeconomic variables affected private investment negatively.

   Olweny and Chiluwe (2012) investigated the effect of monetary policy on investment in Kenya using the quarterly data from 1996-2009. They used the unit root and vector error correction model (VECM) to identify the short and long run relationship among the variables. The results indicated that public internal debt and treasury bill rate inversely affect private sector investment. Further, increase of money supply and internal saving increased the investment. The results of study suggested that to boost up investment, deposit rates should be attractive and lending rates low.

   Ayeni (2014) examined the effect of major macroeconomic variables on investment in Nigeria using annual time series data from 1979-2012. For the analysis of the data, augmented dickey fuller test, Johansen co-integration and ARDL (for examining the long and short run association) were utilized. The results depicted that the exchange rate, GDP, financing private sector, rate of real interest and rate of inflation were important determinates of the investment in Nigeria.

   Eshun, Adu and Buabeng (2014) using time series annual data from 1970-2010 and applying the ARDL bound test found that the high real rate of interest decreased investment in shorter run as well as in longer run and that unavailability of credit placed restrictions on the investment level. Imoughele and Ismaila (2014) examined the determinant of private saving in Nigeria utilizing the time series data from 1981-2012. They found that the determinants of the private investment in Nigeria are per capita income, inflation rate, financial deepening and term of trade. Ali and Shaheen (2016) examined the determinants of private investment in Pakistan using the time series data from 1980-2011. They found a negative association between inflation and investment. While a positive relationship of gross domestic product, savings and credit with the investment was found.

   Umoru and Ohiomu (2017) explored the link between money supply and investment instability in Nigeria. They used restricted VAR model for analysis. The result of the analysis indicated the existence of co-integration in variables and shock of money supply was the reason of investment instability. They suggested that in Nigeria the policy makers need to focus on the money supply (M2) in implementing the monetary policy. Additionally, it is necessary that government should focus on interest rate management and investment in order to boost real sector activities.

   Ajayi and Kolapo (2018) examined the impact of the gross domestic product, money supply, exchange rate, interest rate and inflation rate on investment of Nigeria. The result indicated that in short run, gross domestic product and exchange rate are positively related to private investment, while money supply was negative related to the domestic private investment. In long run, money supply negatively affects the investment and gross domestic product positively affect the investment.

3. Research Methods

4. Results & Discussion

5. Conclusion

   The study estimated the role of money supply (i.e. M1 and M2) in the determination of the aggregate investment component of aggregate demand for Pakistan during the period 1980 - 2015. First, Hodric Prescott filter method was applied to the data for separating the cyclical components from the trend components of the data for making the data stationary. After that ordinary least squares method was applied for the regression results. Granger Causality test has also been applied for checking the causal relationship between the variables. Vector Auto regression for the robustness of the results also applied. The results showed that monetary aggregates i.e. M1 and M2 positively affect the aggregate investment in Pakistan. Furthermore, the Granger causality test showed a one directional relationship from M1 and M2 towards aggregate investment. Similarly, the Vector Auto regression also supported these results and revealed a positive relationship between money supply and aggregate investment. Furthermore, Gross Domestic Product growth rate and saving also turned positively significant. However, foreign direct investment remained insignificant. It is concluded on the basis of that monetary policy aggregates both M1 and M2 play an important role in the determination of the aggregate investment in Pakistan.


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