Impacts of Money Supply, Inflation and Exchange Rate in Kuwait - Term Paper Example

Time series investigation of the impacts of money supply, inflation and exchange rate variations on GDP in Kuwait Introduction Effective management of any economy through policy depends crucially upon a proper understanding of the interrelationships between the important macro-variables. The present paper examines a fundamental macroeconomic relationship, namely that of the Gross Domestic Product (GDP) with money supply, inflation and exchange rate in Kuwait. The primary concern is to identify the effectiveness of money supply and exchange rate as transmission mechanisms into the real economy. It should be noted at the outset that Kuwait is a small open economy characterized by a relative factor abundance of oil resources. It is majorly a state dictated economy and it maintains a pegged exchange rate against a basket of currencies. It is surprising to note that 9% of the entire world’s crude oil reserves lie within the relatively smaller geographical boundaries of this nation. Thus, understandably, 50% of GDP, 90% of exports and 95% of the Governments revenue is attributable to Petroleum in Kuwait. The economy however does not have any arable land and additionally, its water resources are also very scarce. So, there is not much scope of primary production in Kuwait. However, since it is abundant in one of the most essential resources in the world, Kuwait has retained its spot as one of the richest economies in terms of per-capita income. Exploring macroeconomic relations in Kuwait is particularly interesting because these above mentioned features make it distinct from the standard large economies which form the basis for macroeconomic theory. Neoclassical, Keynesian and post Keynesian macro- economic doctrines have all evolved from the primary motive of explaining much of the economic history of the US economy since the great depression. While all major developing economies saw detrimental output and employment trends in the mid 1970s due the oil price shock, this was a period of unprecedented economic growth for oil-producers like Kuwait. It would be therefore interesting to explore the nature of macroeconomic relationships in an economy which is evidently distinct compared to the economies that have served as benchmarks for standard textbook macroeconomics. This paper explores how changes in money supply, inflation and exchange rate affect the GDP. It is found that increases in money supply have a relatively small but significant positive impact on the GDP. Increases in the exchange rate are found to have a very strong negative impact on the GDP. Finally, there seems to be no significant effect of variations in inflation on the GDP. The paper is structured as follows: section 2 presents a basic review of literature to provide a context and indicate possible expected results; section 3 discusses the data and presents basic summary statistics. The basic empirical specification is stated, and the research questions are translated into testable hypothesis. In section 4, the results are presented and analyzed. Finally, section 5 summarizes the findings and concludes. Literature review Empirical literature on the macro-economy of Kuwait is yet to be developed to any degree of substantiality. There is no literature that explores the particular relationship for Kuwait or for similar economies that this author is aware of. However, there are numerous instances of research that attempts to identify how monetary policy affects the real economy, namely the real GDP through the channels of money supply and exchange rates. Regarding inflation, it is usually agreed based on the empirical success of the Neo-Keynesian model that using monetary policy to maintain long term stability of inflation is optimal since low and stable inflation promotes economic growth (Abel, Bernanke and Smith, 2003). According to Eduardo and Berg (2000) higher levels currency substitution possibly reduce the efficacy of traditional monetary policy tools. Thus, for such economies, money supply rises are likely to result in insignificant effects on GDP. However, as mentioned above, the Kuwait economy maintains a peg against a basket of currencies thereby implying a moderate level of currency substitution only. Therefore, we should expect to find some effects of money supply increases. In recent literature, quite a few authors have found that in developed economies, money supply does have real effects on the economy at least in the short run. Evidence for such effects has been provided for the US economy (Giovanni and Gordani, 2006) and for the New Zealand economy (Citu, 2003). The results are not so pronounced for economies in transition. Although tendencies for positive real effects have been found, in majority of the cases these have not been established as being statistically significant (Hafer and Kutan, 2001; Starr, 2004). There is some consensus regarding the exchange rate transmission channel particularly that relevant to a small open economy like Kuwait. It has been found that smaller the economy and the more open it is, the better it is served, i.e., the exchange rate variations therefore should be expected to have substantial impacts [Kim and Rubini (2000); Cîtu (2003); Ribnikar, (2004)]. Thus, the upshots from the literature that form the context of the empirical analysis are: (i) Money supply should have a significant but small impact on GDP (ii) Exchange rate variations are likely to have substantial impacts on GDP (iii) Stable inflation should be associated with higher growth. Data and empirical model In order to empirically explore the questions, a time series data set is compiled for the Kuwait economy. The data are annual, covering 1971-2010. The variables used are real GDP and money supply in million Kuwaiti Dinar, the Dinar – Dollar exchange rate and finally the CPI inflation. In Figures 1 through 4, the time plots of these variables are presented to provide a preliminary snapshot about what to expect. Figure 1 GDP over time In figure 1 above, GDP across time is presented. A very sharp rise is noted from the early 2000s which suffered a steep fall beginning around 2008 reflecting the effects of the global financial crisis. Figure 2: Time plot of money supply In figure 2 above, the time plot of money supply is presented. Observe that this plot seems to be a smoothed version of the GDP plot in terms of observable trend. This reflects a possible association that should be expected based on the results found in the literature reviewed. Figure 3: time plot of exchange rate As can be seen from figure 3, the exchange rate has been very volatile. Although this may be initially surprising given that Kuwait follows the pegged regime, it is explained by the fact that the peg holds for the nominal exchange rate while the variable under consideration is actually the real Dinar-Dollar exchange rate. Figure 4: Inflation in Kuwait over time Finally, the inflation as is evident from figure 4, has been quite steady after the initial spurt of the 1970s which declined as sharply in the late 70s. From early 1980s, CPI inflation has been relatively stable. This stability is what should be anticipated given the high growth rates that have been sustained by Kuwait. The summary statistics of these variables are presented below. Table 1 Descriptive Statistics GDP Money Supply Exchange Rate Inflation Mean 11100.67 Mean 7696.468 Mean 291.3874 Mean 75.58684 Standard Error 1614.092 Standard Error 1028.881 Standard Error 1.603641 Standard Error 6.699158 Median 7186.65 Median 6316.4 Median 291.735 Median 81.15 Standard Deviation 9949.933 Standard Deviation 6342.449 Standard Deviation 9.885506 Standard Deviation 41.29639 Sample Variance 99001170 Sample Variance 40226656 Sample Variance 97.72323 Sample Variance 1705.391 Kurtosis 2.015025 Kurtosis 2.042607 Kurtosis -0.22197 Kurtosis -1.16711 Skewness 1.752453 Skewness 1.544106 Skewness -0.49508 Skewness 0.050234 Range 38535.53 Range 25090.9 Range 38.25 Range 144 Minimum 1463.97 Minimum 571.9 Minimum 268.54 Minimum 7.1 Maximum 39999.5 Maximum 25662.8 Maximum 306.79 Maximum 151.1 Sum 421825.6 Sum 292465.8 Sum 11072.72 Sum 2872.3 Count 38 Count 38 Count 38 Count 38 From the table above, it is evident that all variables have undergone substantial variations and therefore, using a regression specification is valid. The empirical specification is ... (1) Here, MS represents money supply, ExRt stands for Exchange Rate, and is the random error or the disturbance term. Since we are interested in examining whether money supply, exchange rate and inflation have any impacts on Kuwaity GDP, our testable hypothesis are the following: (i) (ii) (iii) Results and analysis Table 2 below presents the results of estimating the specification stated as equation (1) using OLS. The upper half of the table presents the value of the estimated coefficients, standard errors, t-ratios computed under the null hypothesis of insignificance and the associated p-values, and finally the 95% confidence intervals. The lower half presents indicators about the validity of the model itself, namely, the R squared and adjusted R squared values, the standard error of regression, the value of the F statistic computed under the null hypothesis of the coefficients being jointly insignificant and finally the associated p-values. Table 2: predicting GDP by money supply, exchange rate and inflation in Kuwait Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Intercept 47067.19 15306.34 3.08 0.00 15960.96 78173.42 Money Supply 1.45 0.16 9.19 0.00 1.13 1.77 Exchange Rate -163.98 54.24 -3.02 0.00 -274.21 -53.75 Inflation 9.12 25.36 0.36 0.72 -42.41 60.64 R Square Adjusted R Square Standard Error F Significance F 0.95 0.94 2428.07 195.77 0.00 The first point to note is the values of the coefficients and more importantly their signs. The estimated intercept takes a very large positive value. The t-stat and the p value imply that this coefficient is significant. Thus, the autonomous (for the estimated model) portion of GDP is very large. Money supply has a positive but relatively small coefficient. The t-stat and the p-value imply that the null hypothesis (i) is rejected. Therefore, as anticipated, a small but positive significant impact of money supply on GDP is found. The exchange rate has a quite a large negative coefficient. The t-stat and the p-value show that the null hypothesis (ii) is rejected. Therefore, it is found that an increase in the real Dollar value of the Dinar is associated with a substantial decline in the GDP. This should be expected since Kuwait is primarily dependent on its petroleum exports and a rise in the real exchange rate implies a fall in demand for exports. Since these exports form a very large portion of the GDP, this rise in the real exchange rate affects the GDP inversely. However, because the elasticity of demand for oil is typically small, the impact is not as large as it would be if the primary export good was something associated with a relatively elastic demand, Inflation has a positive coefficient implying that it does lead to GDP rises, but the t-stat and p-value implies that the null hypothesis (iii) cannot be rejected in this case. Finally, from the lower half of the table, it can be seen that the parameters measuring the fit of the model reflect a very good fit (very high R squared and adjusted R squared values). Additionally, the F stat and the p-value implies that the null hypothesis that the coefficients are jointly insignificant is rejected. The validity of these results however critically depend upon the extent to which the underlying assumptions of the OLS model hold. So, it is important to test for deviations in terms of multicollinearity, heteroscedasticity and autocorrelation. To test for Multicollinearity, first the correlation matrix is evaluated (table 3). There is evidence of high association between inflation and money supply (correlation coefficient of 0.86). Table 3: Correlation matrix   Money Supply Exchange Rate Inflation Money Supply 1   Exchange Rate -0.04011 1   Inflation 0.859172 0.306575 1 However, formally testing for multicollinearity in table 4, using Variance Inflating Factors (VIF) fails to find evidence of multicollinearity to any problematic extent. The mean VIF is lower than 5 (although those for inflation and money supply are higher). None of the individual VIFs exceed 10. Thus, it can be concluded that the results are not confounded to problematic extents due to the presence of multicollinearity. Table 4: Testing for multicollinearity using VIFs The second concern is that of Heteroscedasticity. Table 5 presents the results of running a Breusch-Pagan-Godfrey test. Table 5: Heteroskedasticity Test: Breusch-Pagan-Godfrey F-statistic 8.972811     Prob. F(3,34) 0.0002 Obs*R-squared 16.79131     Prob. Chi-Square(3) 0.0008 Scaled explained SS 16.73419     Prob. Chi-Square(3) 0.0008 The F-statistic and the probability in the table shows that the null hypothesis of homoscedasticity is rejected. Therefore, heteroscedasticity is a potential problem for the results. It should be noted however, that in the presence of heteroscedasticity the estimates are still consistent and unbiased. The confidence intervals however tend to get skewed. Finally, to evaluate the extent of autocorrelation, first a time plot of the fitted residuals is explored to see if there are any observable patterns of persistence. Figure 5: Fitted residuals Figure 5 reveals that there is indeed some evidence of persistence. A decline seems to persist for some periods as does a rise. However, the volatility seems to be centered around a zero mean. Table 6 Breusch-Godfrey Serial Correlation LM Test: F-statistic 14.15049     Prob. F(1,33) 0.0007 Obs*R-squared 11.40431     Prob. Chi-Square(1) 0.0007 Table 6 above presents the results of a formal Breusch Godfrey serial correlation LM test. The null hypothesis is of non-autocorrelation, and the test rejects this null. Therefore, autocorrelation is another potential problem for the validity of the inferences made. Figure 6: Actual versus fitted values Figure 6 simply presents a plot of the actual versus fitted model. From this graph it can be seen that the estimated model is a pretty good fit to the data thus confirming the high R squared values. Conclusion This paper has attempted to empirically estimate how money supply, real exchange rate and inflation impact the real GDP of Kuwait. It was found that an increase in money supply leads to a positive although not very large increase in the GDP. The real exchange rate was found to have a substantially larger but negative impact on the real GDP. This supports the position of Eduardo and Berg (2000). Inflation was found to have a positive impact on GDP. However, the coefficient was found to be insignificant. Therefore, for the small open economy of Kuwait, the exchange rate seems to be the more effective mechanism of transmission for the real GDP. This is not unexpected since Kuwait is substantially dependent on its oil exports which in turn depend to some degree on the real exchange rate. Therefore, to conclude, the implication for policy is that using the real exchange rate as its target variable can therefore be more beneficial than a monetary stimulus to boost GDP. However, potential problems of autocorrelation and heteroscedasticity were identified and this coupled with the significance of the results obtained reflects the need for future research with robust specifications that treat these problems. If these conclusions are found valid even then, the results will have significant implications for Kuwaiti macroeconomic policy. References Abel, A B, Bernanke, B S & Smith, G (2003) Macroeconomics (3rd ed.), Toronto: Pearson Cîtu, F (2003) A VAR Investigation of the Transmission Mechanism in New Zealand, Reserve Bank of New Zealand. Eduardo, B & Berg, A (2000) Full Dollarization, IMF Economic Issues, No. 24. Hafer, R W & Kutan, A M (2001) Determining the Money-Output link: International Evidence, Working Paper, No.19, Center for European Integration Studies Kim, S & Roubini, N (2000) Exchange Rate Anomalies in Industrial Countries: A Solution with a Structural VAR Approach, Journal of Monetary Economy, (45), 561-860 Ribnikar, I (2004) Exchange Rate Regimes and Monetary Arrangements, Journal of Economics and Business, 50 (2), 9-23. Read More