Monetary Sector Analysis of Bangladesh- Causality and Weak Exogeneity

Abstract

Money supply can affect both income and price level – which is the baseline theory of monetarist. Keynesians view, on the contrary, is that money does not play an active role in changing income and prices. In reality, change in income causes increased demand for money which changes money stocks, implying that the direction of causation runs from income to money without any feedback. Granger Causality test on Bangladesh economy shows the proof of Keynesian view, i.e. real GDP causes an increase in money supply. Analysis delineates that there is a significant cointegration relationship between real GDP, broad money and CPI. A VECM analysis shows significant error correction terms for both broad money and CPI but not for GDP. Then a weak exogeneity test is done for GDP. This monetary sector analysis proves that GDP is weakly exogenous implying that GDP has a smaller role in short-term adjustments.

Keywords: VECM, Monetary Sector, Granger Causality, Weak Exogeneity.