Relationship between money supply, output and price level in India

This paper investigates causal relationships among three macroeconomic variables for India. For that purpose, study has undertaken time series data for the period from 1950-51 to 2016-17. Lag length is selected using standard criteria – LR, FPE, AIC, SC and HQ through VAR estimation. Long run and short run estimates have been investigated using Johansen Co-integration and Vector Error Correction approached. Causal relationships have been observed using Granger causality test. The estimation of vector error correction model based on VAR indicates that there exists a bidirectional causality relationship between price level and growth of output in India whereas there are unidirectional causal relationship runs from money supply to inflation and growth of output in the long run. However, in the short-run, the bidirectional causality exists between money supply and price level and unidirectional causality exists from output to price level. Study concludes that money supply is effective tool to tame inflation in India. It has a positive effect on inflation as expected. Growth of Output has negative effects on inflation. Monetary theories indicate that an increased money supply in an economy often helps to increase or moderate inflationary targets. The supply side of inflation is a key component for the rising inflation in India and an increase in GDP may positively persuade the control of inflation.