“Time Series Analysis” Course Thesis

Spring semester of the 2019-2020 academic year, BJUT.

Title: Considering Money Supply as Endogenous and

Exogenous and their impact on Inflation in Pakistan

College： School of Economics and Management

Major: Applied Economics
Student ID: B20191115W
Name : ALI KASHIF （Signature）
Contact way (Mobile phone)：+8617812156985
Date: 24th April, 2020

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 Considering Money Supply as Endogenous and Exogenous and Their Impact on Inflation
in Pakistan

Ali Kashif1

Abstract

Theoretically, both fiscal deficit and money supply are inflationary in nature. In most of the
econometric analysis, money supply is treated as endogenous variable, especially after the
Sargent and Wallace (1981) argument that If fiscal authorities move first and it is backed up by
the monetary policy in such situation money supply should be considered as endogenous.
According to this, that part of total money supply, which is increased for government
borrowing, is endogenous, not all of the money supply. If all of the money supply is used as an
endogenous variable, there may be mismeasurement error in the independent variable.
Therefore, in order to avoid this measurement error, this study aims to test the inflation with
endogenous part of money supply as well as exogenous part of money supply. This study also
aims to find which part of money supply is more inflationary in nature. Based on time series
property of data, i.e. Autoregressive Distributed Lag (ARDL) model is used. This study finds that
endogenous and exogenous parts of money supply were statistically highly significant and
endogenous part of money supply contributes more to inflation in the long run. Based on the
findings of the study, it is recommended that government should reduce government borrowing
from central bank.

Key Word: Inflation, endogenous money supply, ARDL

1
The author is Ph.D. Scholar at Beijing University of Technology, Beijing, China.

2
 1. Introduction

Borrowing is good as well as bad for economic development of any country. It is

beneficial for the economy as long as it is exercised with diligence. Debt problem arise for those

governments if they have no debt servicing capacity or their debt servicing does not grow with

the growth of debt (GOP, 2008). In this situation borrowing hits the economy. Besides other

problems, high interest rate, unstable exchange rate, one of the major problems that may arise

from such kind of borrowings is the high inflation. Inflation is continual rise in general price

level in an economy, and, it’s been generally related with the monetary expansion. Pakistan is

experiencing the same as all other countries do (Agha and Khan, 2006). However, it’s been

generally argued that in developing countries fiscal imbalances might have a key role in spelling

out the fluctuations in the price level (Catao and Torrens, 2005). As both the Classical model

and Keynesian model of the economy suggest that fiscal deficit can shift aggregate demand to

the right more than the aggregate supply, which leads to increase in the price level (Abel. et. al,

2008)

In different economies fiscal deficit is financed through various methods i.e. printing of

money, using foreign reserves, borrowing from external sources, and borrowing domestically

(Fischer and Easterly, 1990).

According to Sargent and Wallace (1981), those governments who have prolonged fiscal

deficit have to, sooner or later; finance this deficit with monetization causing high inflation in the

long run. They also argued that the nature of the money supply, endogenous or exogenous,

depends on the move of the fiscal and monetary authorities. If fiscal policy moves first and it is

backed up by the monetary policy in such situation money supply should be considered as

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endogenous. If it is considered true, even then total changes in the money supply are not fully

endogenous, some portion may be exogenously determined. So this allows us to bifurcate the

total money supply into two parts, endogenous and exogenous parts of the money supply.

According to Sargent and Wallace (1981), that portion of the total money supply which is

increased for government borrowing may be considered as endogenous money supply. Total

government borrowing is comprised of borrowing for budgetary support, borrowing for

commodity operations and others, while the exogenous part is the gap between total money

supply and net government borrowing.

In case of Pakistan, the decade wise distribution of money supply is given in the

following chart.

Bifurcation of Money Supply in Pakistan

66
70
56 59
60 52 54
48 46
50 44 41

40 34
30

20

10

0
1976-80 1981-90 1991-2000 2001-2010 2011-14

Endogenous Part Exogenous Part

Source: State Bank of Pakistan

According to the above facts and figures, in all the decades, more than 40 percent of the

total money supply is increased exogenously. In such situation, total money supply considering

as endogenous may be miss-measurement and may cause some serious issues in the analysis.
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Most of the studies in Pakistan such as, Hussain and Zafar (2018), Sarfaraz and Anwar (2009),

Agha and Khan (2006), Malik (2006), Kemal (2006) Qayoum (2006) used money supply as

endogenous in their models.

1.1 Problem Statement

As in inflation models money supply is the independent variable, errors of measurement

in the independent variable (money supply) causes the estimators not only biased but also

inconsistent that is they remain biased even if the sample size n increases indefinitely, Gujarati,

D. (2008).

1.2 Objectives of the Study

This study attempts to test inflation with money supply bifurcated as endogenous part as

well as exogenous part, and tries to find that which portion of money supply is more inflationary.

1.2 Organization of the Study

The study is structured as follows; in section two we have presented selected review,

section three outlines the methodology and describes the data, section four presents the results

discussion and section five concludes with few policy suggestions.

2. Selected Literature Review

Classical school of thought presented the dynamics of inflation though quantity theory of

money (QTM). According to Irving Fisher (1911), an increase in the money supply would result

an increase of price level in the economy with same proportion. However monetarist school of

thought following the same QTM but does not support the proportionality relationship between

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money supply and inflation. Further Friedman (1956), the most prominent monetarist, stated

“inflation is always and everywhere a monetary phenomenon” which shows that money supply is

exogenously determined by monetary policy. On the other hand Sargent and Wallace (1981)

contradicts with monetarists that it is budget deficit which determines the money supply in the

economy and thus leads to inflation. Sargent and Wallace (1981) showed the way of interaction

between fiscal and monetary authorities. They argue that if fiscal authority moves first and

decide independently about budget and revenues generated through sale of government bonds

and seignorage, then sooner or later government will have to monetize this fiscal deficit, leading

to more inflation in the economy. Therefore, money supply is endogenous and inflation is a

fiscal driven phenomenon. But Leeper (1991) and Sims (1994) present the idea of fiscal theory

of price level (FTPL) strongly suggesting that inflation is fiscal phenomenon. This theory shows

that how fiscal and monetary authorities interact and influence the price level in the economy.

They put forward considerations that the government deficit must be financed in a sustainable

manner and inter temporal budget constraint should be balanced. Sims (1994) reinforces that in

most of the cases inflation is more of a fiscal phenomenon and is dependent upon the

expectations of the people have regarding fiscal policy and fiscal deficit. However FTPL is

empirically tested for many countries which provides mix results.

Literature related to Pakistan gives some mix result. Kemal (2006), Malik (2006),

Qayyum (2006), found money supply and output growth are responsible for inflation in Pakistan,

using Johanson cointegration test, Vector Auto Regressive model and Autoregressive Distributed

Lags model (ARDL) respectively. According to these studies inflation is a monetary

phenomenon in Pakistan. These studies used money supply as endogenous variable but ignored

fiscal deficit to be an important factor in determination of inflation in their studies. Although

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Mukhtar and Zakaria (2010) included money supply and fiscal deficit both in their econometric

modeling and found that inflation is monetary phenomenon but Shabbir and Ahmad (1994) have

different results that fiscal deficit is directly linked with inflation. Agha and Khan (2006) using

Johanson Cointegration technique also found that changes in inflation do not take place only by

the money supply but also by the fiscal deficit. This support the argument that in Pakistan,

inflation is a fiscal phenomenon. Ammamma and Mughal (2011) show that deficit strongly effect

inflation in Pakistan using Granger causality test from 1960-2010. Same results were found by

Jalil and Bibi (2014) using panel ARDL model. The results are in line with Chaudhary and

Ahmed (1995), suggesting that money supply is not exogenous but it is endogenously

determined by foreign reserves, domestic borrowings and credit to commercial banks.

The review of the literature shows that money supply, fiscal deficit both contribute to inflation in

the long run. To the best of the reviewer knowledge, no study has been conducted in which

money supply has been split up into two parts, endogenous and exogenous. Therefore, this study

aims to bifurcate the money supply and fulfill the literature gap.

3. Theoretical Background and Estimation Method

The prolonged relationship that exists between the variables is well indicated by the theory. This

section shows that how general equilibrium models surveyed by Ljungqvist and Sargent (2000)

of a small open economy can be modified and extract a parsimonious and testable specification.

In this model, money is playing a significant role in recognizing the macroeconomic equilibrium

through reducing the transaction cost, which enables a fiscally influential government to effect

nominal money demand and inflation. The model shows that generally inflation growth rate is

equivalently equal to the nominal budget deficit and changes in money stock. Therefore,

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 CPI t =f (FD t , dM t ) (01)

The equation (01) shows that inflation (CPI t ) is a function of fiscal deficit and money

supply Now to fulfill our objective of the study we can bifurcate the changes in money supply

d M t into exogenous part of money supply (M 2 ENDO) and endogenous part of money supply

(M 2 EXO ). The endogenous part of money supply (d M 2 ENDO t ) is that part of money, which is

borrowing for budgetary support, borrowing for commodity operations and others. The

exogenous part is the gap between total money supply and net government borrowing.

Therefore, the equation becomes as follows;

CPI t =FD t +d M 2 ENDO t + d M 2 EXOt (02)

To evaluate the desired objective equation (02) is estimated as per time series analysis.

The data of has been collected from State Bank of Pakistan (SBP), Ministry of Finance (MOF)

and Pakistan Bureau of Statistics (PBS) for the period of 1976 to 2014.

3.1 Estimation Method

As this study deals with the time series analysis. Time series data has its own issues. The

most common issue is the non-stationarity. A series is said to be weak or covariance stationary if

it’s mean, variance and auto covariance do not affect by the change of time origin. In classical

linear regression model (CLRM), regression analysis assumes that all the variables must be

stationary. If they are not stationary, there may be problem of nonsense regression. A nonsense

or spurious regression is a regression in which the model seems to be very good in terms of R 2

and t-statistics but having no economic meaning, as the ordinary least square (OLS) estimators

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are biased and statistical inferences are not valid2. So testing of a series’ stationarity is very

important, for this purpose, Augmented Dickey Fuller test is used.

3.1.1 Augmented Dicky and Fuller Test (ADF)

Dickey and Fuller (1979) formulate a test to formally examine the existence of a unit root

in the data using Random Walk model with different specifications.

The Dicky and Fuller test equations are;

∆ y t =γ y t−1 +ϵ t (03)

∆ y t =a 0 +γ y t −1+ ϵ t (04)

∆ y t =a 0 +a2 t+ γ y t −1 + ϵ t (05)

They main difference among the three is the presence of the deterministic elements of intercept

a 0 and trenda 2 t . Equation (03) is the pure random walk model while (04) and (05) includes

intercept and trend respectively. In the above three models γ =0 represents a unit root in the

series.

The Dicky and Fuller (1979) assumes that error term is normally, identically and

independently distributed (n.i.i.d). But most of the time they are not independent, in the presence

of auto correlation Dickey and Fuller test does not predict the unit root accurately. To handle this

problem Dickey and Fuller introduce the augmented lags 3. And hence the test is known as

Augmented Dickey Fuller (ADF) test. The three specification of the ADF test can be

represented as follow;

2
Granger and Newbold (1974)
3
Lags of the dependent variable∆ y t .

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 p
∆ y t =γ y t−1 + ∑ β i ∆ y t−i +1+ μ 1t (07)
i=2

p
∆ y t =a 0 +γ y t −1+ ∑ β i ∆ y t −i+1 + μ2 t (08)
i=2

p
∆ y t =a 0 +a2 t+ γ y t −1 + ∑ β i ∆ y t −i +1+ μ 3 t (09)
i=2

This ADF models have same testing procedure, γ <0 leads to the conclusion of no unit root in

the process.

3.1.2 Auto Regressive Distributed Lag Model

Both Engle and Granger (1987) and Johansen (1988) cointegration tests involves data to

be stationary at first difference. If some of the variable are stationary at level and some are at

first difference then both tests cannot be used for cointegration analysis. In such situation Auto

Regressive Distributed Lag (ARDL) model may be used. In general, to estimate the long run

relationship, if Y t is an explained variable, where X t is independent variable, long run model has

following form;

Y t =α 0 + β 1 X t +ε t (10)

Where ε t is a white noise error term. The ARDL (p , q) can be written as,

p q
∆ Y t=α 0 +α 1 Y t −1+ α 2 X t −1+ ∑ βi ∆ Y t −i+ ∑ γ j ∆ X t − j + μt (11)
i=1 j=0

To check the long run relationship, coefficients on the one period lagged value of Y t and X t in

equation (11) are jointly tested i.e. H0: α 1=α 2=0 , through F–Test.

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This null hypothesis expressed no cointegration between Y t and X t . Critical bound for the joint

significance is obtained for the cases where there are I(1) regressors purely and purely I(0)

regressors or mutually cointegrated.

This F-test does not follow a standard distribution, rather it depends on the following factors;

a) The order of the integration 4 , b) Number of regressors. c) Intercept and/or trend in the model

and d) Sample size

Therefore, instead of using the critical values given by Pesaran and Pesaran (1997) as

well as Pesaran et.al (2001)5, this study will incorporate the critical values presented by the

Narayan (2005) for small sample. If the calculated F-statistic falls in the critical bound then there

results are inconclusive6. If F-statistic is less than the lower bound, no cointegration is concluded,

while outside to the upper bound then there is long run relationship.

3.2 Data and Variables

This section discusses the nature and the source of the data, how variables are defined

and from what source it’s been taken. They are given under the following heads.

3.2.1 Consumer Price Index (CPI t )

There are many measures of the inflation, some uses consumer price index (CPI),

Wholesale Price Index (WPI), Sensitive Price Index (SPI), GDP Deflator and many more. In

empirical analysis, CPI is the most commonly used gauge of the level of prices in an economy

(Mankiw, 2005). Therefore, this study also incorporate CPI as a measure of inflation.

4
Variables are I(0) or I(1)
5
The critical bound by Pesaran et.al (2001) was generated for 500 and 1000 observations, which can be used in
large sample size. As this study is related to only 38 observations therefore, the critical bounds given by Narayan
(2005) are used for testing the bound test of cointegration.
6
Inconclusive means that we are not sure about the status either there is long run relationship or not.

11
 CPI measures the cost of living of a consumer in a specific time period. CPI is the

changes in retail price level. In Pakistan CPI is computed through the Laspeyer’s formula;

CPI t =
∑ ( Pt|P0 ) W i∗100
∑ Wi

Where

Pt = Price of a commodity in the current year

P0 = Price of the commodity in base year

Wi = Weight assigned to the ith commodity in the base year (SBP, 2015).

3.2.2 Fiscal Deficit (FD ¿¿ t) ¿

Budget deficit is the difference between total revenue and expenditure during fiscal year

of an economy. In Pakistan fiscal year starts from July, and, ends at June of the next year. Total

revenue is the pool of the total tax revenue and non-tax revenue in a fiscal year. While total

expenditure is the sum of total current and developmental expenditure during a fiscal year. So

budget deficit is calculated as;

BD t=TR t−TE t

Where

BD tis the budget deficit in period t

TRt is the total revenue that is generated in period t and

TEt is the total expenditure in period t

If FD t is the fiscal deficit and SAB t is the surplus of autonomous bodies and Dt is the

discrepancies then budget deficit can be converted into fiscal deficit by;

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 FD t=BD t + SAB t −Dt

It is expected that inflation is positively associated with fiscal deficit.

3.2.4 Endogenous Part of Money Supply (M2ENDO)

Money supply is the amount of money that circulates in the economy. As most of the

researcher uses M2 for empirical analysis, this study also incorporate broad money (M2) as a

measure of money supply but only that portion which is used for borrowing to the government in

budgetary support, commodity operations and others. i.e.

M 2 ENDO t =Borrowing for(Budgetory support +Commodity operations +others)

3.2.5 Exogenous Part of Money Supply (M2EXO)

The exogenous part of money supply is the difference between total money supply(M2)

and endogenous part of money supply M 2 ENDO t .

M 2 EXO t=M 2t −M 2 ENDO t

3.3 Data Source

The data of the above-mentioned variables are collected from State Bank of Pakistan

(SBP), and from various issues of Pakistan Economic Survey, issued by Ministry of Finance

(MOF). Variable wise data source and time span is given in Table 1.

Table 1 Variables and Their Source of Data Collection

Variables’ name Time Span Data Source

Consumer Price Index (CPI) 1976-2014 State Bank of Pakistan7
Fiscal Deficit (FD) 1976-2014 Pakistan Economic Survey
7 8
Cross checked with Pakistan Bureau of Statistic (PBS)

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 Endogenous Part of Money supply (M2ENDO) 1976-2014 Pakistan Economic Survey
Exogenous Part of Money Supply (M2EXO) 1976-2014 Pakistan Economic Survey

4. Results and Discussion

Results of econometric analysis are discussed in this part. This portion is organized as follow;

section 4.1 shows the result of the ADF test, while section 4.2 presents the result of the

cointegration analysis.

4.1 Result of Augmented Dickey Fuller Test

As the starting point of time series analysis is to test the stationarity of the given data. For this

ADF test was used. The result of the unit root testing of ADF is given in the following table.

Table 2 Result of ADF Test

VARIABLES9 AT LEVEL AT FIRST CONCLUSION
DIFFERENCE

cpit -2.688 -3.117* I(1)

fd t -2.442 -5.304* I(1)

m 2 endot -4.422* _______ I(0)

m 2 exot -0.567 -5.245* I(1)

According to Table 2. all of the variables are integrated of order one except log of endogenous

part of money supply that is integrated at level. All of the variable show time trend in the plot

and were statistically individually as well as jointly significant, therefore, they were tested with

time trend and intercept. Similarly, after differencing the variables, they were showing non-zero

mean, therefore, intercept term was added in the ADF test specification. These intercept terms

8
Cross-checked with the Hand book of Statistic on Pakistan Economy 2010, SBP
9
Small alphabets represents that variables are in log form.

14
were statistically significant. The error of the each series was tested for white noise properties i.e.

they are normally identically and independently distributed around zero mean.

4.1 Results of ARDL

As variables in the analysis are integrated of order zero and one, therefore, in such

situation ARDL is the best option to use for checking the existence of long run relationship

among variables. To find the long run relationship equation (02) was run through ARDL

approach while specifying the appropriate lag length of one lag 10. On the basis of AIC11 04

models were evaluated and ARDL (1, 0, 1.) was selected. The results of the ARDL (1, 0, 1.)

model is presented in Table 3.

Table 3: Results of ARDL

Variable Coefficient Std. Error t-Statistic Prob.*

cpit −1 0.7753 0.0833 9.3079 0.0000

fd t -0.0148 0.0244 -0.6051 0.5494

m 2 endot 0.2012 0.0565 3.5616 0.0012

m 2 endot −1 -0.0930 0.0524 -1.7746 0.0855

m 2 exot 0.0408 0.0197 2.0708 0.0465

C -0.8636 0.3288 -2.6263 0.0131

R-Square 2
0.9993 χ ARCH ( 1) 0.2467
Std. Error of Regression 2
0.0258 χ ARCH ( 2) 0.2889
2 2
χ auto (1) 1.9784 χ Norm ( 2) 1.0772
2
χ auto (2) 4.3826 F RESET (1 , 27 ) 6.7004

10
All of the criterion LR, SC, and HQ show one lag to be optimal. While FPE shows 2 lags and AIC shows four lags to
be optimal for the analysis.
11
Same model was selected by SIC

15
 The model is best fit in the sense of high R-square, the model is free of specification bias,

and, the estimated error term is free of autocorrelation, heteroscedasticity. The residual of the

model is normally distributed. Therefore, the estimated error term is normally, identically and

independently distributed (n.i.i.d) around zero mean.

4.2 Results of Bound test of Cointegration

After confirmation, that ARDL model has passed all the required tests, the next step is to

test for the long run relationship. The results of the bound test of cointegration is given in Table

4.

Table 4: Bound Test of Cointegration

Test Statistic Value K
F-statistic 2.8637 3
Critical Value Bounds
Significance I0 Bound I1 Bound
10% 2.845 3.623
5% 3.478 4.335
1% 4.948 6.028
Note: Critical values are taken from Narayan (2005) for 35 observations

The null of no cointegration may not be accepted at 5% level of significance, as F-

statistic (2.8637) lies inside of the upper bound (3.623) at 10 percent level of significance.

Therefore, the result is inconclusive; we are unable to decide whether there is long run

relationship or not. However, from the cointegration equation we can confirm whether long run

relationship can be interpreted or not i.e. if the error correction term is negative and significant,

we can conclude that there is long run relationship and we can interpret the long run relationship.

4.3. The Error Correction Mechanism

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 The ECM of the ARDL model shows short run fluctuations along with the error

correction. The results of the ECM is given in Table 5.

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Table 5 : Results of Error Correction Mechanism
Variable Coefficient Std. Error t-Statistic Prob.
ECM t −1 -0.2247 0.0833 -2.6973 0.0111

Δ fd t -0.0148 0.0244 -0.6051 0.5494

Δ m2 endot 0.2012 0.0565 3.5616 0.0012

Δ m2 exo t 0.0408 0.0197 2.0708 0.0465

According to the short run analysis (Table 5) fiscal deficit has play no role in determining

of inflation in the short run, as it is statistically highly insignificant with probability value of

0.5494. While previous year both endogenous part of money supply and exogenous part of

money supply play a major role in determination of inflation in the short run. The reason may be

people may expect more inflation in the next period with increase in government borrowing.

Therefore, they may increase the demand for goods, increasing the price level in the economy.

Correction in the error term is 22.47 % every year, which is abit low. This may be because of the

insignificance of the major variable in the model. However, on the basis of all these analysis we

can say both endogenous part of money supply as well as exogenous part of money supply are

inflationary in nature in the short run. Once it is concluded that short run fluctuation converges to

its long run equilibrium, we can now interpret the long run relationship.

4.4 Results of the Long Run Relationship

The estimated relationship between inflation, fiscal deficit, endogenous and exogenous

part of money supply, in the long run, are given in the equation (12).

^ t =−0.0658 fd t +0.4817 m2 endot +0.1815 m2 exo t −3.8435

cpi (12)
( 0.1148 ) ( 0.1134 )( 0.0466 )( 0.1852 )

The long run estimates indicates that fiscal deficit has no role in the long run to influence

the inflation, as the coefficient of fiscal deficit is highly statistically insignificant. Both

18
endogenous part of money supply and exogenous part of money supply play significant role in

determination of inflation in Pakistan i.e. both coefficients of endogenous and exogenous part of

money supply are highly statistically significant even at 1% level of significance.

As both coefficients have positive signs and statistically significant coefficients, we can

find that which part of money supply is contributing more to inflation in Pakistan. Compare both

coefficients of endogenous part of money supply and exogenous part of money supply. The

coefficient of endogenous part of money supply (0.4817) greater than the coefficient of

exogenous part of money supply ¿), showing that endogenous part of money supply is more

inflationary in nature as compared to the exogenous part of money supply.

5. Conclusion and Policy Recommendations

The basic objective of this study was to figure out which part of money supply is

contributing more to inflation in Pakistan. For this purpose, money supply was divided into two

parts, the endogenous part of money supply, the changes in money supply for government

support, and the exogenous part of money supply. Based on unit root results, Autoregressive

Distributed Lags (ARDL) model was deployed on the data. ARDL(1,0,1) was selected on the

basis of AIC. The model was statistically good in health i.e. there was no problem of

autocorrelation, heteroscedasticity and normal distribution of error term. According to Bound

Test, the result was inconclusive, however, the error correction term was negative and

significant, therefore, we were able to interpret the long run relationship. The result indicates that

endogenous part of money supply plays more important role in determination of money supply

as compared to the exogenous part of money supply.

Based on the findings of the study following recommendations are put forwarded in order

to control inflation in Pakistan.

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 1. As endogenous part of money supply were contributing more to inflation in

Pakistan, and endogenous part of money supply is comprised of borrowing for budgetary

support, borrowing for commodity operations and others. It is therefore, recommended

that the government should discover more avenue of financing its fiscal deficit.

2. Future study is recommended to find the new ways of financing fiscal deficit,

which are less inflationary in nature.

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