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A CAUSALITY ANALYSIS FOR PAKISTAN ECONOMY

(QUARTERLY DATA ANALYSIS)

Qazi Muhammad Adnan Hye*

ABSTRACT

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.

INTRODUCTION

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,

Pakistan.

194 Q. M. A. Hye

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.

METHODOLOGY

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

analysis.

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 )

of ρ so that serial correlation does not influence the asymptotic distribution of

test statistic. PP test is based on following statistic:-

1

~ γ 2

T ( f 0 − γ 0 )( se( ρ~ ))

tρ = t ρ 0 − 1

− − − − − − − (2)

f0 2 f0 2 s

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)

T

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

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

196 Q. M. A. Hye

series. Consider a VAR of order p.

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

deterministic variables, and Єt is a vector of innovations. We can write the

VAR as

p −1

∆ y t = Π y t−1 + ∑

i=1

Γi∆ y t − 1 + Bx t + ε t − − − − − − − (5 )

where

Π = ∑ i

A i − I , i = 1 , ⋅ ⋅ ⋅ ⋅ ⋅ ⋅ ⋅, ρ

Γ i = − ∑

j = r + 1

A i − − − − − − − (6 )

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.

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

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 .

RESULTS AND DISCUSSION

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.

Ln(AP) -2.68 -17.01*

Ln(MS) -2.92 -16.31*

*Significant at P=0.01

Optimal lag based on AIC.

198 Q. M. A. Hye

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.

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)

Yamamoto modified wald test.

χ2

MS does not Granger Cause AP 10.64 0.05

AP does not Granger Cause MS 8.53 0.13

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.

CONCLUSION

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

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.

REFERENCES

1. Asfaha, T.A. and A. Jooste. 2007. The effect of monetary changes on

the relative agricultural prices. Agrekon. 46(4): 460-474.

2. David, A. B, R. C. Barnett. and R. L. Thompson 1983. The money

supply and nominal agricultural prices. Amer. J. Agric. Econ. 65(2):303-

307.

3. Devadoss, S. and W.H. Meyers.1987. Relative prices and money.

further results for the United States. Amer. J. Agric. Econ. 69: 838-842.

4. Engle, R. F. and C.W. J. Granger 1987. Co-integration and error

correction: Representation, estimation, and testing. Econometrica.

55(2):251-276.

5. Frankel, J.A. 1986: Expectations and commodity prices dynamic: The

Overshooting Model. Amer. J. Agric. Econ. 67: 344-348.

6. Hye, Q.M.A. 2009, Agriculture on the Road to Industrialization and

Sustainable Economic Growth: An Empirical Investigation For Pakistan

Economy. Paper Presented in 5th ISOSS Conference, Lahore.

7. Johansen, S, 1991. Estimation and Hypothesis Testing of Cointegration

Vectors in Gussian Vectors Autoregressive Models. Econometrica. 59:

1551-1580.

8. Peng, X, M.A Marchant and M.R Reed. 2004. Identifying Monetary

Impacts on Food Prices in China: A VEC Model Approach. Paper

Presented in the American Economics Association Annual Meeting.

Denver, Colorado. August 1-4, 2004.

9. Phillips, P.C. and P. Perron. 1988, Testing for a Unit Root in a Time

Series Regression. Biometrica. 75: 335-346.

10. Saghaian, S. H., M. R. Reed and M. A. Marchant. 2002. Monetary

Impacts and Overshooting of Agricultural Prices in an Open Economy.

Amer. J. Agric. Econ. 84: 90-103.

11. Toda, H. Y. and T. Yamamoto 1995 Statistical Inference in vector

autoregressions with possibly integrated processes. J Econometrics.

66: 225-250.

12. Tweeten, L.G. 1980. Macroeconomics in crisis: Agriculture in an

underachieving economy. Amer. J. Agric. Econ. 62: 853-865.

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