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Money supply and agricultural prices 193


Qazi Muhammad Adnan Hye*

The present study was conducted at Applied Economics Research Centre,
University of Karachi, Pakistan during 2008. This study empirically investigates
the cointegration and causal relationship between agricultural prices and
money supply during a period 1971 to 2007. For empirical analysis JJ
cointegration for long run and Toda Yamamoto Modified Granger Causality Test
for causal association were used. The results show that a long run relationship
existed between both variables and long run elasticity of agricultural prices
with respect to money supply is 0.79. The causality analysis indicates
unidirectional causality from money supply to agricultural prices. Thus money
supply is not neutral in determining agriculture prices in an agricultural based
economy of Pakistan.

KEYWORDS: Money supply; agricultural prices; economy; Pakistan.

Agriculture sector plays a vital role in the process of economic growth of the
country. It contributed 21.5 percent to GDP during 2008. For desirable
economic growth sustainability in agricultural growth is necessary (6).
Agricultural prices are important for maintaining agricultural growth, farmer’s
living standard and investment decisions. Thus factors that influence the
agricultural prices is a fundamental issue. Conventional agricultural
economies examine that agricultural prices are determined by the interaction
of supply and demand forces. The latest studies on agricultural economies
examined that macroeconomics, particularly monetary factors, affect the
agricultural prices. Tweeten (12) finds that monetary shocks have a little
effect on agricultural prices. David et.al. (2) empirically indicates
unidirectional causality from money supply to agricultural prices in Brazilian
data. Frankel (5) argues that monetary policy has significant effects on

*M. Phil Student, Applied Economics Research Centre, University of Karachi, Karachi,

J. Agric. Res., 2009, 47(2)

194 Q. M. A. Hye

agricultural prices as there is flexible compared to other goods prices.

Devadoss et.al (3) support the hypothesis that agricultural prices faster
respond than manufacturing product prices to change money supply in U.S.A.
Saghaian, et.al (10) empirically demonstrates that in long run money
neutrality does not hold in determination of agricultural prices. Peng et.al (8)
observed monetary variables impact on food prices in China. Asfaha and
Jooste (1) reject the money neutrality hypothesis and also explain that in case
monetary shock occurs, agricultural sector will have to bear the burden of
adjustment because of increase in farmers’ financial vulnerability.
Most of the empirical research regarding monetary shocks impact on
agricultural prices was conducted on well developed market economies.
Comparing with these markets, Pakistan’s agricultural commodity markets
are not well developed. But due to financial reforms in Pakistan, it is
anticipated that monetary policy plays more vigorous role, affecting
agricultural prices in Pakistan. Hence, it is important to verify the monetary
impacts on Pakistan agricultural prices through quantitative methods.
The present study was conducted to explore causal relationship between
money supply and agricultural prices in Pakistan by employing JJ
cointegration for long run relationship and causal relationship determined
through Toda and Yamamoto (11) modified granger causality test.

The study covers quarterly data from 1971 to 2007 phase. Broad money
supply (M2) (measured in million of rupees) was taken from international
financial statistics and agricultural price index (quarterly) developed by
author. Both series were transformed in natural logarithm for econometric

J. Agric. Res., 2009, 47(2)

Money supply and agricultural prices 195

This empirical work uses Phillips and Perron (9) unit root test to determine
time series properties. Phillips and Perron (PP) test proposes an alternative
(non-parametric) method of controlling for serial correlation while testing unit
root of time series data. PP method estimates non-augmented Dickey Fuller
equation (1). The test detects the presence of a unit root in a series, say Xt by
estimating as

∆X t = α + ρ X t −1 + ε t − − − − − − − (1 )

PP test estimates the modified t-value associated with estimated coefficient

of ρ so that serial correlation does not influence the asymptotic distribution of
test statistic. PP test is based on following statistic:-

~ γ  2
T ( f 0 − γ 0 )( se( ρ~ ))
tρ = t ρ  0  − 1
− − − − − − − (2)
 f0  2 f0 2 s

where ρ~ is the estimate and t ρ the t-ratio of ρ , se( ρ~ ) is coefficient

standard error and s is the standard error of test regression. In addition, y0 is
a consistent estimate of the error variance (in eq.1) which was calculated as.

(T − k ) s 2
γ0 = − − − − − − − (3)

where k is the number of regressors and T tabulated value. Remaining

term, f 0 , is an estimator of residual spectrum at frequency zero. The series
is stationary if ρ is negative and significant.

JJ cointegration test

If hypothesis of non-stationary is established for the underlying variables, it is

desirable and important that time series data are examined for cointegration.
Engle and Granger (4) approach for cointegration is simple and popular for its
certain agreeable attributes. This study used maximum likelihood procedure
of Johansen (7) because this is based on well-established likelihood ratio
principle. The advantage of Johansen’s procedure is that several
cointegration relationships can be estimated and it fully captures the
underlying time series properties of the data. Johansen’s method tests the

J. Agric. Res., 2009, 47(2)

196 Q. M. A. Hye

restrictions imposed by cointegration on unrestricted VAR involving the

series. Consider a VAR of order p.

y t = A1 y t −1 + ⋅ ⋅ ⋅ ⋅ ⋅ ⋅ ⋅ + A ρ y t − ρ + Bx t + ε t − − − − − − − ( 4 )

where yt is a k-vector of non-stationary I(1) variables ,xt is a d-vector of

deterministic variables, and Єt is a vector of innovations. We can write the
VAR as
p −1
∆ y t = Π y t−1 + ∑
Γi∆ y t − 1 + Bx t + ε t − − − − − − − (5 )

Π = ∑ i
A i − I , i = 1 , ⋅ ⋅ ⋅ ⋅ ⋅ ⋅ ⋅, ρ

Γ i = − ∑
j = r + 1
A i − − − − − − − (6 )

Granger’s representation theorem asserts that if coefficient matrix П has

reduced rank r < k, then there exist k × r matrices α and β each with rank r
such that П = α and yt stationary is the number of cointegrating relations
(the cointegrating rank) and each column of β is the cointegrating vector.
The elements of α are known as the adjustment parameters in vector error
correction model. Johansen’s method is to estimate the П-matrix in an
unrestricted form, and then test whether we can reject the restrictions implied
by reduced rank of П. Johansen’s method uses two test statistics for the
number of cointegrating vectors: the trace test and maximum eigenvalue
( λ max ) test. The ( λtrace ) statistic tests H0, that the number of distinct
cointegrating vectors is less than or equal to r against a general alternative.
The second statistic tests H0 that the number of cointegrating vectors is r
against the alternative of r+1 cointegrating vectors.

Toda and Yamamoto modified Granger causality test

To establish a causal relationship between monetary expansion, and

agricultural prices, we also employed a modified version of Granger
causality test, which is robust for cointegration features of the process.
This procedure was suggested by Toda and Yamamoto (11) to overcome
problem of invalid asymptotic critical values when causality tests are
performed in presence of non-stationary series. This procedure essentially
suggests the determination of d-max, i.e. maximal order of integration of

J. Agric. Res., 2009, 47(2)

Money supply and agricultural prices 197

series in the model, and to intentionally over fit the causality test underlying
model with additional d-max lags- so that VAR order is now ρ = k + d , where
k is the optimal lag order.

Toda and Yamamoto (11) augmented Granger causality test was obtained in
present study by estimating a two equation system using the seemingly
unrelated regressions (SUR) techniques. Therefore, model can be specified
as follow:-
k +d k +d
Ln( AP ) = ∑ α 1i Ln( AP ) t −i + ∑ β 1i Ln ( MS ) t −i + µ1t − − − − − (7)
i =1 i =1
k +d k +d
Ln ( MS ) = ∑ α 21i Ln( MS ) t −i + ∑ β 2i Ln( AP ) t −i + µ 2t − − − − − (8)
i =1 i =1

where Ln(MS) and Ln(AP) are respectively the natural logarithms of money
supply and natural logarithms of agricultural prices. ‘ k ’ is the optimal lag
order, d is the maximal order of integration of series in system and µ1 and µ 2
are error terms that are assumed to be white noise. Conventional Wald tests
were then applied to first k coefficient matrices using standard χ 2 -statistics.
The main hypothesis set can be drawn as in equation (7), money supply
“Granger-causes” agricultural prices if it is not true that β1i = 0∀i ≤ k ; in
equation (8), agricultural prices “Granger-causes” money supply if it is no true
that β 2i = 0∀i ≤ k .

The results about the order of integration of series, derived from Phillips and
Perron (PP) unit root test (Table-1.) indicate that natural logarithms of
agricultural prices and natural logarithms of money supply are not stationary
in their levels. But stationary after first difference of both variables, the null
hypothesis of no unit root is rejected at 0.01 significance level.

Table 2. Phillips-Perron unit root test.

Variable I(0) I(1)

Ln(AP) -2.68 -17.01*
Ln(MS) -2.92 -16.31*
*Significant at P=0.01
Optimal lag based on AIC.

J. Agric. Res., 2009, 47(2)

198 Q. M. A. Hye

After both series were found to be integrated of order one, cointegration

hypothesis between variables is examined by Johansen cointegration test
(Table 3). Using the trace statistic test, null hypothesis of no cointegrating
vector (R=0) can be rejected at 5 percent level of significance, while null
hypothesis (R ≤ 1 ) cannot be rejected, the results indicating one cointegrating
vector. Therefore, results support the hypothesis of cointegration between the
agricultural prices and money supply. At the bottom of Table-3, estimated
cointegrating vector shows positive long run elasticity (equal to 0.79) of
agricultural prices with respect to money supply.

Table 3. Johansen cointegration test.

Null hypothesis Trace statistic 5 percent critical value

R=0 64.56 20.26
R≤1 8.13 9.17
Cointegration equation { normalized to Ln(AP)}
Ln(AP) = 2.17 + 0.79 Ln(MS)

Table 4. Test for Granger-causality applying Toda and

Yamamoto modified wald test.

Null hypothesis P-Value

MS does not Granger Cause AP 10.64 0.05
AP does not Granger Cause MS 8.53 0.13

The underlying model for the two-equation system is a SUR model;

the lag order (k) is 1 based on AIC.

The results of causality wald test, obtained from SUR estimations are
illustrated in Table- 4. Null hypothesis that money supply does not cause
agricultural prices can be rejected at 10 percent level of significance. On the
other hand, hypothesis that agricultural prices do not cause money supply,
cannot be rejected at 10 percent level of significance. Thus, there is
unidirectional causality from money supply to agricultural prices in case of
Pakistan’s economy.


The study concludes; first, there is one cointegrated vector between money
supply and agricultural prices. Secondly, estimated cointegrated vector
indicates 0.79 long run elasticity of agricultural prices with respect to money
supply. Thirdly, causal analysis demonstrates that there is unidirectional
causality from money supply to agricultural prices. Present findings guide to

J. Agric. Res., 2009, 47(2)

Money supply and agricultural prices 199

policy implication that in long run money supply positively causes agricultural
prices. This implies that loose monetary policy can be used to boost the
agricultural prices which leads to an increase in farmer’s income or to use
tight monetary policy in order to control agricultural prices for easing
consumers. This study also recommends that closed managed coordination
is necessary between monetary, agricultural policy makers and price control
authority to achieve desired goals to facilitate consumers or farmers.

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