Relationship between Money Supply and Inflation in Saudi Arabia - Math Problem Example

Relationship between Money Supply and Inflation in Saudi Arabia Introduction Over the recent past, the effects of money supply, debt and inflation have become contentious issues for debate. Furthermore frequent cautions concerning the risk of very large budgetary deficits, aver that this would send up the upcoming state debt and capital rate as indicated by the rates (interests). As a nation, Saudi Arabia has a bi and enduring budgetary deficit over the pas two decades and the government has been forced to go into the market so as to have a loan access and to make up for the deficits. Given the impact of this on inflation and other economic variables, its imperative and of great alarm for strategy architects (strategists) to understand how microeconomics have an effect on money supply, financial plan deficits and the way these activities can influence the line of monetary development. Relevant econometrics will be employed in this document to show the correlation involving money supply and inflation. Hence it’s probable that borrowing from the domestic market to supplement the government budget could reduce financial resources for the private sector and hence investments are greatly discouraged. Money Supply: The Definition Generally, money supply can be defined as the overall or the sum of the cash amount that is in circulation or is available in a particular country. Money supply on the other hand can be equated to the monetary base (i.e. the total worth). In order to understand monetary base comprehensively, two alternative empirical definitions will be provided in the literature. Relationship between Money Supply and Inflation Lucas (1995) has always put emphasis that there is a long run connection connecting money supply to prices of goods. Inflation and money supply cannot be separated and where there is inflation, there is monetary phenomenon. The increase in money supply is the root cause of increase in prices of commodities and this is what constitutes the central dogma of inflation. Inflation has been categorized as either domestic or imported. This is because inflation may come as a result of increased cost of imports (high prices on imported goods) and services from within the country or due to the monetary exchange rates (Jackson & Miles 2006). Inflation is hence the product of the interrelations between money supply and production. Bearing this convention in mind, economist theories are divided into three schools; 1. The ones that believe the process itself is the determining factor (Keynesian) 2. those who believe that the monetary effects are determinants (monetarists) 3. those who believe that production (supply) is the determining factor showing lack of products (goods and services) as dominant factor that causes inflation Internal inflation is as a result of increased supply and credit. Inflation can also be described as undue increase of a country’s currency or expansion of the cash amount particularly issuance of paper money not redeemable in specie. According to monetarists, monetary effect on inflation is as a result of money supply and that the increase rate is faster than that of national income growth. The quantity theory of money derives the following expression: M V = P Y Where (M) is money supply, (V) is velocity of money, (P) is the price index, plus (Y) as real income. Monetarists assert the velocity V to be fixed while the national income (Gross Domestic Product) Y is determined by supply factors and is hence independent variable affecting money supply. Accordingly, there is a direct correlation in existence. If a considerable rise in the money supply, the extent at which price height will go up by the same margin. By this perception, a rise in the money supply would lead to a similar boost in cumulative demand in the short-run the rise would cause another rise in the actual degree of output. On the other hand, there would be an increase in earnings which will cause and increase in inflation and thus the expenses that companies will face; by this, the short term aggregate supply curve would take a left shift. The out put level as a consequence would go back to the original extent but with prices that are of maximum level Government borrowing is also another critical view of inflation cause. The government’s central bank may sell short term bonds to the other commercial banks; these are in most cases very highly liquid and are guarantees for borrowing. An increased money supply thus ensues. Methodology By a factor of some straightforward accounting identities and denoting the GDP- gross domestic product by Y, Government spending (purchases) by G, revenues/taxes by T, consumption by C, and, then private saving will be represented by Y-T-C, plus the Nation’s saving is T-G. Summing up these expressions gives a state saving, expressed as S: Y - C – G = S 1 The additional critical accounting factor is division of the Gross domestic income - GDP into 4 categories of expenditure; government expenses, investments, consumptions and net exports I + C + NX + G = Y 2 Where output Y is the total C- Consumption; I- investment; G- government purchases; and NX – Net-Exports. But S =Y - C – G, so by Substitution this terms for Y gives: + NX = S 3 From the above straightforward equation we can deduce that the national saving is equal to the summation of net exports (NX) and Investment (I). After a budget shortage or when less money supply trim down state saving, investment must be reduced, reduce the net-exports or reduce the two events together. The sum of decrease in investments plus net-exports has to accurately equal the drop in the state saving. The most common quantification of budget shortage is the finding subtraction of government expenses from taxes and/or revenues: DEF = G – T 4 Where: DEF- Budget Deficit; G- Government Expenditure; T- Government Revenue The effect of state budget deficit on private investment can be devised as below: f (Y. DEF. i. inf.) = I 5 Where: I- Private sector investment; Y- GDP- gross domestic product; i- interests; inf. = the current economic inflation. For the reason of estimation, expression (4) can be written as: I/Y= a + Y + DEF / Y + i + inf +e 6 Some scholars include public savings and accessibility to loans by the private segment as added features in their opinion of private venture factor in emerging economies. I/Y= a + Y + DEF/Y + GI/Y + CPS/Y + i + inf + e 7 In this equation: GI/Y represents proportion of public savings in relation to the nation’s GDP while CPS/Y is the proportion of loans or credit accessible in relation to the private segment and to the GDP. Further studies by Granger indicated that incase the point in time series variants are not stagnant, the entire the regression outcomes with the sequence will vary from the traditional regression hypothesis with stagnant series. i.e. The regression coefficient will be very misleading and spurious (Cheng 2006). For this reasons, investigation of time sequence characteristics of these variables studied in macro economic studies is specifically critical for the examination of the relationships among variables exhibiting similar trend. Money Supply % Change Though the GDP- gross domestic product is a very good in portraying the general height of monetary growth and activities in the least type of an economy, it can still be disputed that in a nation like Saudi Arabia that these are not a true representations of the economic activities. This is attributable to the inability of the economy to influence level of oil production and the oil prices at the global market. Oil mining and export are the dominant constituents of government revenue and hence gross domestic product. Largely, the economic activity within the nation is decided by external system in which the government has very little control over. Hence as oil based economy, Saudi Arabia activities are mostly linked to oil. This is a very important aspect though over the last 20 or so years the importance of oil on the economy has been declining but still a determinant factor. There’s is extensive information that analyses inflation and budget deficit in relation to money supply. Sargent and Wallace for instance have shown that for some particular reasons, if the time series of state expenditure and revenues are external shortfall that are bond financed will be non-sustainable hence the central bank has to in the long run monetize these deficits (Dwyer 1992). This is bound to increase money-supply and inflation eventually. There is contention over the consequence of budget deficits on the inflation and currency supply. Most studies have found no conclusive outcomes on the budget deficit and inflation relationships in short or long run. Particularly Barro (1978), McMillin and Beard (50) and Niskanen (29) did not find any proof that states deficits were analytically interconnected to currency increase and therefore inflation (Ahking & Miller 1995). Nonetheless, other researchers like Allen and Smith (33), Hamburer and Zwick, Dwyer (26) and Hoffman et al (27) found out that there was some evidence to show that government deficits were methodically connected to currency increase and caused a considerable inflationary force on the financial system of the nation in the long-run, nevertheless an increase in the non-monetized debt affected inflation by causing a negative outcome in the short run (Hamburger & Zwick 1991). Ahking and Miller (28) carried out modeled deficit analysis of money growth an inflation of the period ranging from 1950 to 1980 by use of a tri-variete autoregressive procedure and the results indicated that government deficits were inflationary in 1950 and 1970s but in 1960s they were not (Miller 2003 and Ahking, F. & Miller, S. (1995). Using rational expectations Choundhary and Parai (41) with a macro model of Peruvian inflation found that there was a substantial growth rate of money supply that had a considerable impact on inflation (Choudhary & Parai 1991). Miller explains that government deficits are inflationary regardless of them being monetized or not. To him, deficit policies cause inflation via 3 means: monetary powers may be obliged to go into monetary accommodation of the deficits. Even when these powers don’t monetize shortages, inflation will still ensue via classified monetizing and crowding out (i.e. non monetizing causes high rates). When the interest rates are high, crowding is seen in private venture, there is reduced growth rate or actual output, by means of a certain money supply result into high costs. Elevated interest rates moreover encourage the monetary sector to become more innovative in their imbursement structure in addition to causing state bonds to be more changeable for cash. Government spending can be explained by use of the Wagnerian hypothesis where the economic development process, the economic activities by the state in elation to the private sector increased according to the private sector activity (Ahsan et al 1996). Government spending is an internal factor or rather an endogenous feature. Granger causality of economic growth and other economic activities related to this can be indicated according to the following expression; (1) GS = α + β1 EG + β2 EV + μt Where: GS = Government Spending, EG = Economic Growth, EV = Other Explanation Variables (descriptive), and μt = Error Term According to Wagner, there are 3 explanations for this case. 1. The administration role of the nation as well as those of protecting the public interests and private doings. 2. - monetary growth can cause an increased civilization and wellbeing expenses. 3. the administration interference can be needed for management and financing natural monopolies (Cheng 2006). Nonetheless, the connection between monetary development and civic expenses is considered to be reverse in the view under Keynesian economy. A fiscal spreading out is predictable as an outcome of multiplier results of the assumptions on pricing rigidity and possibility of excess capacity (O’Sullivan & Sheffrin, 2003). When the output is equivalent to the demand, a four model can be used to indicate this; (Output = demand = {(C + I + G + (X – M)} Where: C = consumption, I = investment, G = government spending, (X-M) = net export. A lot of issues cause some outcome on the enlargement of an economy. The implication of the economy on wealth is also addressed by the growth theory. Basic assumption in most of the economic theories is that the growth rate is affected during transition of these economies in their steady state. Consequently many of the researches concentrate on the “division and stabilization of the cake” rather than on the enlargement. Several scholars have continuously been challenging the role of the government in these theories. The state can either influence the growth directly or indirectly. Apart from the government expenses, there are several factors that affect the long term growth and they include supply of revenues, private investments, populace, and degree of openness, globalization, trade intensity, political stability, and fiscal policies and political freedom. Conclusions The economic variables that are commonly stationary not in levels but in the initial distinctions; this usually calls for the application of the Augmented- Dickey Fuller (ADF) test which offers the assurance that the likelihood organization of the variables are steady in addition to they being eligible for consequential regression expression -. Augmented- Dickey Fuller (ADF) test helps to eliminate the null hypothesis of series is foremost distinction fixed; ∆ Yt = β 1 + β 2 t + ζ Yt-1 + α ∑ ∆ Yt-1 + ε t……………………………….. 1 Where; ∆ Is the Difference Operator, Yt Is The Economic Variables, Yt-1 Is Their Lagged Differences to Make Sure the Residuals are White Noise, in addition to ε t As The Stationary Random Error (Dickey And Fuller, 1981). The test is carried out for all the quantities in level form first. As per the report, no one of the test statistics can be used to eliminate the null hypothesis of non-stationary seeing as integrated ADF could not surpass decisive values of ADF in the base (Johansen 2001). It appears that, each series is not stationary in level form Table 1 Test Results for Unit Roots VARIABLES Augmented Dickey-Fuller Statistic Height of Variability First Difference Government Expenditure -2.989877 -3.431298 Monetary Growth -1.7648709 -3.984323 Private venture -2.7379439 -3.894312 Revenues Supply -0.1288398 -3.329812 Rates of Employment -3.8743987 -5.398312 Public debt (PD) -1.9874324 -3.231987 level of Openness -2.9874331 -5.432987 The critical values for ADF are -4.987, -3.2434, and -3.3124 for 1% 5% and 10% respectively. Another important aspect is the Johansen co-integration procedure, it’s very critical to establish lag duration of the variance expression (VAR) that could be elevated sufficiently to errors though small to be estimated they still are white noise. The lag length k used for analyzing this data was selected on the foundation of least amount of worth of Akaike Information Criterion (AIC). Johansen suggested a method for investigating long-run association between state expenditure and monetary expansion plus to make sure that the regression is not forged (Johansen 2001). The time series Xt, is assumed by Johansen that it’s the same process is modeled as a vector autoregressive (VAR) representation in the structure: ∆Xt = α + ∑ τi Xt-1 + π Xt-1 + λDt + η t Where Xt is the vector of non-stationary that contains government expenses and real GDP, ∆ is the initial -difference, α is a constant expression, Dt is fixed sequence, and η t is the indiscriminate error. References Ahking, F. & Miller, S. (1995). The Relationship Between Government Deficits, Money Growth, and Inflation. Journal of Macroeconomics, 7 (1995) Ahsan, S., Kwan A., & Sahni B. (1996). Co-integration and Wagner’s hypothesis: time series evidence for Canada. Applied Economics (28), Allen, S. & Smith, M. (1993). “Government Borrowing and Monetary Accommodation.” Journal of Monetary Economics, 12 (1993), 607-619 Cheng, J. (2006).  Exchange Rates and Prices. A Revisit of Granger Causality Tests. Journal of Post Keysenian Economics, 29 (2), 261-285. Choudhary, M. & Parai, A. (2001). “Budget Deficits and Inflation: The Peruvian Experience.” Applied Economics, 23 (2001), Dwyer, G. (1992). Inflation and Government Deficits. Economic Inquiry, 20 (1992), 315-329 Granger, C. & Newbold, P. “Spurious Regressions in Econometrics.” Journal of Econometrics, 2 , 111-120. Granger, C. (1996). “Developments in the Study of Co-integrated Economic Variables.” Oxford Bulletin of Economics and Statistics, 48 (1996), 213-228. Hamburger, M. & Zwick, B. (1991). Deficits, Money and Inflation. Journal of Monetary Economics, 7 141-150. Jackson, A. & Miles, W. R. (2006). Fixed Exchange Rates and Disinflation in Emerging Markets: How Large is the Effect?   Johansen S. (2001). Estimation and Hypothesis Testing of Co-integration Vectors in Gaussian Autoregressive Models. Econometrica, 59 () Miller, R. L. (2003). The Macroview Economics Today. Pearson Education Inc. Addison Wesley Sargent, T. & Wallace, N. (2001). “Some Unpleasant Monetarist Arithmetic.” FRB-Minneapolis-Quarterly Review, 5 (5), 1-17. Read More