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Long Run Relationship between Money, Output, and Inflation

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This paper examines the long run relationship between the monetary base and other monetary aggregates with the permanent income and inflation rates predicated on the assumption that the velocity turn over of money is stable over time. Both the cusum square test and unit root test tend to confirm the absence of stability of M1 velocity. However, M2 and M3 velocity tends to be sample sensitive. Our estimation results reveal that the growth rates of monetary aggregates are strongly cointegrated with the growth rate of real GDP. There is an absence of any contemporaneous homogeneity between growth rate of money and inflation over the sample period. However, the correlation is positive and significant at six quarter lag between the current inflation and growth rate of money 18 months earlier. The error correction regression reveals that both M1 and M2 velocities are cointegrated with the yield on the 90-day Treasury and the 10 year notes. While there is evidence of strong co-integration of growth rate of M2 and GDP over the long term and subsequent periods of 1958-81, there is no evidence of co-integration in the 1982-2005, a period of low inflation in the United States. While inflation and above normal growth have tended to coincide in the past, it is important to appreciate that this can happen because growth is sometimes associated with other changes that put upward pressure on prices, not because growth is inflationary in nature. The policy makers should rethink the conventional wisdom of high growth and inflation.

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Article provided by Camera di Commercio Industria Artigianato Agricoltura di Genova in its journal Economia Internazionale / International Economics.

Volume (Year): 61 (2008)
Issue (Month): 4 ()
Pages: 687-709

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Handle: RePEc:ris:ecoint:0019
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