The causal relationship between money supply, inflation and economic growth in vietnam

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE CAUSAL RELATIONSHIP BETWEEN
MONEY SUPPLY, INFLATION AND ECONOMIC
GROWTH IN VIETNAM

BY
NGUYỄN TRỌNG TÍN

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, DECEMBER 2013


UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE CAUSAL RELATIONSHIP BETWEEN
MONEY SUPPLY, INFLATION AND ECONOMIC
GROWTH IN VIETNAM

A thesis submitted in partial fulfillment of the requirements for the degree of
MASTER OF ART IN DEVELOPMENT ECONOMICS

By
NGUYỄN TRỌNG TÍN

Academic Supervisor:
Assoc. Prof. Dr. NGUYỄN VĂN NGÃI

HO CHI MINH CITY, DECEMBER 2013


Declaration

“This thesis is submitted in partial fulfillment of the requirements for the
degree of Master of Art in Development Economic to Vietnam - The
Netherlands Programme.
I certify that the thesis has not already been submitted for any degree.
To the best of my knowledge, the thesis comprises only my original work.
All sources used have been cited and acknowledged in the thesis.”

Nguyễn Trọng Tín

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Acknowledgement
I would like to express my deep gratitude to my academic supervisor,
Assoc. Prof. Dr. Nguyễn Văn Ngãi for his advices and helpful comments in this
thesis.
My dearest thanks to Assoc. Prof. Dr. Nguyễn Trọng Hoài and Dr Phạm
Khánh Nam, who gave me many profound comments when this thesis was just
in form of ideas. My special thanks to Dr Nguyễn Hoàng Bảo and Dr Phùng
Thanh Bình, I would not complete this thesis without their support in term of
econometric techniques.
I would like to thank to all lecturers and staffs at the Vietnam –
Netherlands Programme for their knowledge and patience during the period I
studied at the program.
Finally, I would like to thank to my family, close friends, colleagues for
their love and everything they gave me in life.

ii


List of Abbreviations

ADF

Augmented Dickey-Fuller

AIC

Akaike’s Information Criterion

AS-AD

Aggregate Demand – Aggregate Supply model

CPI

Consumer Price Index

ECT

Error Correction Term

GDP

Gross Domestic Product

GSO

General Statistic Office

HQ

Hannan-Quinn information criterion

IFS

International Finance Statistic

LR

Likelihood ratio test

M2

Broad money

PP

Phillips and Perron

SIC

Schwarz’s Information Criterion

VECM

Vector Error Correction Model

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Abstract
This study analyzes the causal relationships between money supply,
inflation and economic growth in Vietnam in the period of 1999Q2 – 2012Q3.
Quarterly macroeconomic data were collected from IFS and GSO. The thesis
employs the Granger test in the Vector Error Correction Model (VECM)
environment to find the Granger causal nexus of three variables for both in short
run and long run.
There is one cointegration was found from Johansen’s test for cointegration. The results show that there is a bidirectional relationship between

economic growth and inflation for both in the short run and long run, and there
are two unidirectional causalities from money supply to growth and inflation.
However, there is no evidence for the effectiveness of monetary policy in the
short run.

Keywords: Johansen cointegration test, Granger causality, VECM,
money supply, inflation, economic growth

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TABLE OF CONTENTS

Declaration ......................................................................................................... i
Acknowledgement ............................................................................................. ii
List of abbreviations.......................................................................................... iii
Abstract ............................................................................................................ iv
Table of contents .................................................................................................v
List of tables ................................................................................................... viii
List of figures .................................................................................................... ix
CHAPTER 1: INTRODUCTION.....................................................................1
1.1. Problem statement...................................................................................1
1.2. Research objectives.................................................................................4
1.3. Research questions..................................................................................4
1.4. Scope of the study and methodology .......................................................5
1.5. Organization of the thesis........................................................................5
CHAPTER 2: LITERATURE REVIEW .........................................................6
2.1. Theoretical literature ..............................................................................6
2.1.1. Theories about the Inflation – Economic growth relationship .........6
2.1.2. Theories about the Inflation – Money supply relationship ...............9

2.1.3. Theories about the Money supply – Economic growth relationship .
............................................................................................................... 11

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2.2. Empirical literature ............................................................................... 14
2.3. Conceptual framework .......................................................................... 17
CHAPTER 3: RESEARCH METHODOLOGY, MODEL
SPECIFICATION AND DATA SOURCES .................................................. 19
3.1. Analytical framework ........................................................................... 20
3.2. Data sources.......................................................................................... 22
3.3. Model specification............................................................................... 22
3.4. Stationary and Unit root tests ................................................................ 24
3.5. Johansen’s test for Cointegration .......................................................... 26
3.6. Granger Causality Test.......................................................................... 27
3.7. Impulse response functions ................................................................... 30
3.8. Variance decomposition ........................................................................ 30
CHAPTER 4: FINDINGS AND DISCUSSION ............................................. 31
4.1. An overview of inflation, money supply and economic growth in
Vietnam from 1995 to 2012 ......................................................................... 31
4.1.1. Inflation ........................................................................................ 31
4.1.2. Money supply ............................................................................... 34
4.1.3. Economic growth.......................................................................... 37
4.2. Unit root testing .................................................................................... 38
4.3. Estimation optimal lag for the model .................................................... 40
4.4. Johansen cointegration test.................................................................... 40
4.5. Causality test for the long-run and short-run effect................................ 45
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4.6. Comparing with previous studies .......................................................... 48
CHAPTER 5: CONCLUSIONS AND POLICY IMPLICATIONS.............. 51
5.1. Conclusions .......................................................................................... 51
5.2. Policy implications ............................................................................... 52
5.3 Limitation and Further studies .............................................................. 53
REFERENCES................................................................................................ 54
APPENDIX...................................................................................................... 59

vii


LIST OF TABLES

Table 4.1: ADF and PP unit root tests on level time series ............................... 38
Table 4.2: ADF and PP unit root tests on first difference series ......................... 39
Table 4.3: Lag order selection of VAR (p) process ............................................ 40
Table 4.4: Johansen’s cointegration test with 4 lags .......................................... 41
Table 4.5: Inflation equation in VECM model................................................... 42
Table 4.6: Money supply equation in VECM model .......................................... 42
Table 4.7: Growth equation in VECM model .................................................... 43
Table 4.8: Granger causality test base on VECM .............................................. 44
Table 4.9: Variance decomposition ................................................................... 47

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LIST OF FIGURES

Figure 2.1: AS-AD model in the short-run ..........................................................8

Figure 2.2: AS-AD model in the long-run ...........................................................8
Figure 2.3: AS-AD model in the very long-run ...................................................8
Figure 2.4: The causal relationship between Inflation, Money supply and
Economic Growth in theories ............................................................................ 13
Figure 2.5: The conceptual framework of this study .......................................... 18
Figure 3.1: Analytical framework...................................................................... 20
Figure 4.1: Inflation in Vietnam during the periods from 1986 to 1995 ............. 31
Figure 4.2: Inflation in Vietnam during the periods from 1996 to 2012 ............. 32
Figure 4.3: Broad money growth (M2) in Vietnam from 1996 to 2012 .............. 35
Figure 4.4: Correlation between Inflation at year t and Growth rate of Money
supply at year t-1 in Vietnam from 1996 to 2012 .............................................. 36
Figure 4.5: Economic growth (GDP) in Vietnam from 1990 to 2012 ................. 37
Figure 4.6: The causal relationship between inflation, money supply and
economic growth in the short-run ...................................................................... 45
Figure 4.7: The causal relationship between inflation, money supply and
economic growth in the long-run ....................................................................... 45
Figure 4.8: Response of inflation and economic growth to money supply ......... 46
Figure 4.9: Response of economic growth and money supply to inflation ......... 46
Figure 4.10: Response of inflation and money supply to economic growth ....... 47

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CHAPTER 1
INTRODUCTION
In this chapter, I will explain the motivation for doing this thesis and the
importance of the research problem. Research objectives and research questions
are discussed in detail. The scope of the study will be introduced in this section.
Finally, the organization of the thesis will be presented.

1.1 Problem statement

Economic growth and price stability have been the most important goals of
macroeconomics in recent years. However, these goals are not easy to
implement in practice. An appropriate increase in money supply can generate
growth (Tobin, 1965; Bernanke and Gertler, 1995; Levine, 1997), but an
improper expansion in money supply might lead to inflation (Friedman, 1963;
Tobin, 1970). Accordingly, high inflation rate would cause many negative
impacts on economic growth (Fischer, 1993; Barro, 1995; and De Gregorio,
1996). Nowadays, many economists agree with the view that low inflation is
better for the process of economic development. That is why governments often
want to keep inflation at low and stable rates, although sometimes there is a
trade-off between inflation targets and growth objectives. Therefore, an effective
monetary policy founded on deep understanding about dynamic relationship
between money supply, inflation and economic growth is one of the fundamental
conditions for sustainable growth and macroeconomic stability.

In particular, the relationship between growth and inflation, money supply and
economic growth, money supply and inflation have attracted attention and
research efforts of economists as well as concerns of policy makers all over the
world. However, the problem has not been fully settled and has still been in
intense controversy. As a result, there exist many mixed, opposing opinions on

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these issues, both in theoretical and empirical studies. Especially after the global
financial crisis, the instability of the world economy leads to the diminishing
growth rate and increasing inflation over numerous nations.

In many countries, the governments accept the high inflation in exchange for
high growth rate, especially in developing countries, such as China (Lin and
Yunhui, 2005; Xie et al, 2009). In many years, China has achieved high
economic growth by easing the monetary policy in which money has been used
to finance development projects. Thus, the money supply is also the cause of
high inflation in China recent year. Lin and Yunhui (2005) also proposed that
money supply and economic growth boost each other in the long-run, but
inflation. Besides, some countries suffer high inflation with very small growth
rate. An example is the case of Latin America countries in the period 1970-1980.
With their development of financial system in that period, high inflation rate led
to negative effects on the economy and then significantly reduced growth rate
(De Gregorior and Guidotti, 1995). Moreover, some countries print money to
finance the development of infrastructure projects without serious consideration
of potential long-term harmful consequences. The results indicate that the
relation of money supply, inflation and economic growth is mixed.

Although there have been many research works in theoretical, domain including
research on each pair of variables such as money supply and economic growth,
money supply and inflation, inflation and economic growth;

and also

simultaneously all three variables, but all these theories still can not explain the
empirical results to the full extent. Overall, this is one of the most dynamic
research areas in macroeconomics. The obtained results were different from
country to country, from region to region, and from time to time. In such studies,
researchers often use VAR model or VECM model to examine the interaction
between each macro variables to the other, for both long-run and short-run
effect.

2


It is necessary to study carefully the causal relationship between the inflation,
money supply and economic growth for the case of Vietnam to solve many
important macroeconomic issues such as the stabilization of the macro-economy,
the control of inflation or the increase of money supply with sustainable
development. In which case, we should increase money to generate economic
growth without concern about increasing inflation.

The economy of Vietnam has achieved impressive growth in recent years, at the
average rate of 7.52% per year in the period from 1990 to 2007 and 5.87%
during the period from 2008 to 2012, but it has showed signs of slowing down in
the latest years. Many economists believe that Vietnam would not be able to
achieve high growth rates as before. It seems that the existing monetary policy is
gradually losing effectiveness in promoting growth and controlling inflation.
Particularly, inflation was high and dramatically fluctuated during 2008-2012.
Although the causal relationship between inflation, money supply and economic
growth plays a significant role, there is a severe lack of research work on this
field for Vietnam economy. Furthermore, there exist many limitations in
previous studies.

The study of Hoang (2010) showed the relationship between monetary policy to
price level and output, but the results were still only at low levels. Carmen
(2006) studied the volatility of inflation through external factors. Bui (2011)
focused on the impact of monetary policy on inflation in Vietnam. In addition,
there are few other studies on the relationship between inflation, money supply
and growth in Vietnam. However, these studies did not consider all three
variables simultaneously, or did not indicate a causal relationship between these
variables. Recently, in Vo (2013), the author investigated the causal relationship

between money supply, inflation and economic growth in Vietnam. The results
showed that the money supply has an impact on growth and inflation in
Vietnam. However, it was based on unrestricted VAR model, which only
captures the effect of monetary policy on inflation and growth in the short run,
without addressing the relationships in the long term. Similar to many previous
3


studies, Vo (2013) used the percentage change of real industrial output as a
proxy for growth. Notably, this may be not a good proxy for economic growth,
and the results might be biased. Such issues raise the question about the nature
of relationship between these three macroeconomic variables.

Moreover, the relationship between money supply, inflation and economic
growth is very dynamic and changes over time. Therefore, further study is
needed to re-examine this causal complex relationship. In this research, I attempt
to fill the gaps and overcome limitations of previous studies in term of models,
approaches and data.

1.2 Research objectives

In general, the objective of this study is to analyze the dynamic relationships
between money supply, inflation and growth in Vietnam economy. Specifically,
the objectives of this thesis are:

i)

To examine the causal relationship between inflation, money supply and
economic growth in Vietnam

ii)

To propose the implication on monetary policy for the case of Vietnam

1.3 Research questions

This thesis will try to answer the following question:

i)

Is there a causal relationship between inflation, money supply and
economic growth in Vietnam?

ii)

Which monetary policy is suitable for the case of Vietnam?

4


1.4 Scope of the study and methodology

This thesis uses quarterly time series data to examine the nexus between
inflation, money supply and economic growth in Vietnam over the period of
1999 to 2012.

Some key modern methods for exploring time series data including Augmented
Dickey-Fuller (ADF) test, Phillips and Perron (PP) test, Johansen’s cointegration
test, Granger causality test, Impulse response functions, Variance decomposition
were employed in this research.

1.5 Organization of the thesis

This thesis is divided into five chapters. Chapter 1 introduced the problem
statement, the significance of this study, research objectives, research problems,
and the scope of the study in this thesis. Chapter 2 discusses theoretical and
empirical literature and presents an overview of inflation, money supply and
economic growth in Vietnam in recent years. Chapter 3 provides the research
methodology and model specification utilized in the study. Chapter 4 presents
the empirical results and findings of the study as well as the discussion of the
findings. Chapter 5 makes conclusions and proposes policy implications, and
some limitations of the thesis.

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CHAPTER 2
LITERATURE REVIEW
This chapter firstly presents theories on the relationships between inflation and
economic growth, money supply and economic growth, inflation and money
supply. Then, empirical studies for the causal relationship between the three
macro-variables are discussed.
2.1 Theoretical literature
2.1.1 Theories about the Inflation – Economic growth relationship

2.1.1.1 Classical growth theory

Classical growth theory derives from supply-side theories, which emphasizes the
need for incentives to save and invest for economic growth. Adam Smith (1776)
proposed a production function in his famous book “The wealth of nations” as

follows:

Y = f (L, K, T)

(2.1)

Where Y is output, L is labor, K is capital and T is land. Therefore, the total
growth rate of output (gY) depends on the growth rate of labor force (gL), the
growth rate of investment (gK), the growth rate of land (gT) and the change in
overall productivity (gf). We can explain the rate of economic growth by the
following equation:

gY = g (gf, gL, gK, gT)

6

(2.2)


Obviously, land and labor are factors we cannot substantially alter. The idea of
this theory is that savings serve as a source of investment and it in turn leads to
growth. The link between inflation and economic growth is not clearly explained
in this model. However, the relationship between inflation and economic growth
is implicitly suggested to be negative, as indicated by the reduction in firms
profit levels because they must pay the higher wage costs for the labor.

2.1.1.2 Keynesian theory
Traditional Keynesian theory proposes the Aggregate Supply (AS) – Aggregate
Demand (AD) Model, a general model for linking inflation to growth. The
mathematical formulation is:

AD = C + I + G + X – M

(2.3)

Where:
C is consumption
I is investment
G is government spending
X is export
M is import

Alternatively, C, I, G, X, M can be viewed as demand side factors. A suitable
stimulation on the demand side factors can lead to the economic growth.

According to this model, in the short-run, AS curve is upward sloping, and
demand side factors affect the output through AD curve and make it shift to the
right. That leads to the increasing in output and price level. In other words, the
economic growth has a positive relationship with inflation in AS-AD model in
the short-run.

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Figure 2.1: AS-AD model in the short-run

In the long run, the economic growth is determined by factors which influence
the growth of Long Run Aggregate Supply (LRAS) (the PPF of the economy).
All others being equal, or there is no increase in the productive capacity of the
economy, the rise in AD will lead to inflation.

For example, when the AD curve shifts from AD3 to AD4, the result is the price
level will increase, although there is no economic growth.

Figure 2.2: AS-AD model in the
long run

Figure 2.3: AS-AD model in the
very long run
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Figure 2.3 shows an increase in LRAS and AD, leading to an increase in
economic growth without inflation.

In general, the Keynesian theory points out the positive link between inflation
and growth. That is, when growth increases, it leads to an increase in inflation.
However, in the long term, it is difficult to say this relationship is positive or
negative. This relationship totally depends on the characteristics of the economy
of each country, where the relationship between aggregate supply and aggregate
demand over the long term is determined differently.

2.1.1.3 Neoclassical and Endogenous Growth theories

Neoclassical and Endogenous Growth theories treat inflation as an exogenous
variable, when it explains the effects of inflation on growth through the channel
of investment and capital accumulation. When inflation increases, it reduces
investment and capital accumulation, and thus leads to the decrease of growth
rate.

2.1.1.4 The Tobin Effect

The Tobin effect expresses the preference towards the inflation by arguing that it
degrades the actual value of money and thus spurs people to invest their money.
Those investments in turn help to promote the economic development. In
summary, Tobin effect claims that the inflation is positively correlated to the
economic growth.
2.1.2 Theories about the Inflation – Money supply relationship

The monetarism emphasizes the significant role of monetary growth as the
primary cause of inflation. In this perspective first put forward by Friedman
(1989), the inflation is only viewed as a monetary phenomenon in the sense that
the inflation is merely influenced by the monetary growth and hence has no
9


impact on the economic growth. Thus, inflation is the increase in prices of most
commodities in the market, wherever and whenever, it is derived from monetary
causes. Other causes, such as fiscal policy, also have impacts on inflation
through monetary policy, either directly or indirectly as demonstrated
subsequently.

In the economy, supply and demand for money is reflected in the following
formula:

M.V = P.Y

(2.4)

or

P=

Where:

M.V
Y

(2.5)

M is the amount of money in circulation
V is the velocity of money in final expenditures
P is price level
Y is the output

It can be seen that in the short term, V and Y are elements less likely to be
changed; hence, we can assume that V and Y are constant. Therefore, when the
amount of money M in circulation increases, the price level P will increase, or to
put it another way, money causes inflation.

On the other hand, as we have shown in the previous section, the output is a
function of the following factors:

Y=C+I+G+X–M

(2.6)

Thus

P=

M.V
Y

=

M.V
C+I+G+X−M

10

(2.7)


According to equation (2.7), the price level P and the government spending G do
not co-vary in the same direction, given other factors being hold constant. We
can see that price level and inflation do not increase when government spending
increases, if the amount of money in circulation does not increase. Budget
expenditure increases only leads to the increasing in price level and inflation if
money growth is relatively stronger than government spending.

Equation (2.7) can explain for the case that the increasing in the money supply
does not lead to inflation. Specifically, when the amount of money in circulation
increases but at a lower rate than that of government spending, consumption and
investment; the inflation still not occurs. Only when the amount of money in
circulation growth exceeds the growth rate of the economy, it then would lead to
inflation. On the other hand, we already know that the rising in money supply
might have a positive impact on economic growth.

In summary, inflation occurs as consequence of the increase in the money supply

being relatively higher than the economic growth rate.
2.1.3 Theories about the Money supply – Economic growth relationship

Money supply has always played an important role in economic growth process
(Levine, 1997).

Since money affects economic growth through various

channels, monetary policy is a useful tool to promote growth, although
sometimes it causes some unwanted or unexpected consequences (Mishkin,
1995).

Firstly, in a closed economy, an increase in the money supply will reduce
interest rates, which increases investment and accordingly leads to growth
(Mishkin, 1995). Over 70 years, interest rate channel has been the key
component in transmission mechanism to explain how money imposes effect to
the economy.

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Secondly, in an open economy, when the money supply expanding makes the
interest rate of the domestic currency fall relatively to the world’s interest rate,
the stream of foreign currency would flow out of the economy. As a result, the
domestic currency depreciates and this is beneficial for exporters. On top of that,
the nation exports more to the world and this is good for its growth (Mishkin,
1996).

Thirdly, money links with economic growth through capital accumulation. Tobin
(1965) explained that the wealth of household and individual assumes two

forms, capital and money. If the return rate of money is lower than that of the
capital when the central bank increases money supply, people will try to switch
money to capital to increase the total return. In turn, the increase in capital stock
will stimulate economic growth.

Fourthly, money affects economic growth through investment spending channel.
Tobin (1969) proposed a theory later named Tobin’s q1 theory. If q is high, the
market value of enterprises is relatively higher than the replacement cost of
capital. Consequently, businesses have more incentive to spend more money on
investment activities through issuing additional shares and getting more equity.
We all know that increasing in investment spending will lead to economic
growth. Tobin argued that when money supply increases, the public will receive
a higher amount of money than its actual need and hence will find ways to spend
it. One good place to spend money is stock market. It then leads to increasing
demand for equity, and then the rise of price of equity. The whole process can be
summarized as:

Fifthly, money also has an impact on individual consumption through equity
price channel. Modigliani (1971) argued that the major financial wealth of
individuals is common stock. The money supply increase leads to the increasing

1

q is defined as the market value of firms divided by the replacement cost of capital

12


of equity price, and then stock price increase leads to improvement of financial
wealth of households and individuals. Typically, people consume more when

they are wealthier, and that leads to economic growth. In brief, we have:

Sixthly, money supply affects economic growth through credit channel
(Bernanke and Gertler, 1995). When the central bank applies the tight monetary
policy and causes the decreases in bank deposit at commercial bank, it affects
the borrowers. As a consequence, the bank loan reduces, leading to the decline in
investment, and that is bad for growth. In summary, we have:

Besides, economic growth also influences money supply through the
development of financial system (Kuznet, 1955). With the development process
of the economy, we need an appropriate level of money, credit and financial
conditions. This facilitates a more robust development of the financial system,
especially when the economy approaches the intermediate level stage of growth
process. On the other hand, money is the fuel for a functioning financial system
because the development of a financial system requires an adequate supply of
money. In short, there is a way for the opposite effect, that is, economic growth
leads to the increasing in money supply.

Figure 2.4: The causal relationship between Inflation, Money supply and
Economic Growth in theories

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2.2 Empirical literature

Despite the widely accepted belief among the economists on the adverse effect
of very high inflation on economic growth, the empirical studies demonstrate
mixed results regarding their relationship. In a typical study, Fischer (1993) and
De Gregorio (1996) discovered a negative correlation between the inflation and

growth (see also Barro, 1995).

Money plays an important role in the economy. Prahan (2009) found a
bidirectional causal relationship between money supply and economic growth in
India. Money supply is also an important tool to curb inflation. Feldstein and
Stock (1994) stated that the Federal Reserve could probably use M2 as the tool
to reduce the long-term inflation rate and the variance of annual GDP growth
rate. Ogunmuyiwa and Ekone (2010) used annual time series data from 1980 to
2006 to examine the causal relationship between money supply and economic
growth in Nigeria. The Granger causality test was applied in the VAR
environment. The results showed that there is a positive link between money
supply and economic growth at that time. This result is consistent with previous
studies of Odedokun (1996) and Odedokun (1998) which showed a significant
relationship between money supply and economic growth. Furthermore, there
are several other empirical studies supporting the view that there is a strong
positive relationship between money supply and economic growth including
Nouri and Samimi (2011), Owoye and Onafowora (2007), Neusser and Kinglert
(1996), King and Levine (1993), Sims (1972).

Although money can affect both inflation and growth, the empirical results show
that this relationship is different in each country due to different characteristics
of economic activities. In these researches, VAR model or VECM model was
used to examine the potential causal relationship of money supply, inflation and
output, as well as directions of this relationship.

14