THE PAKISTAN DEVELOPMENT REVIEW
Causality Test between Money and Income: A Case Study of SelectedDeveloping Asian Countries (1960-1988)
Money supply in developing countries, like Pakistan plays animportant role. According to classical theory, supply creates its owndemand. Any increase in money supply will give rise to increase inprices only but the effect on output will remain unchanged. TheKeynesians argue that aggregate demand determines output, therefore,fiscal policy is more important. The monetarists on the other hand,argue that in the short run money and only money matters. In the case ofthe rational expectation approach, anticipated changes in money supplyare neutral but short-run unanticipated changes in money supply have arole in determining the growth of output. Monetary policy is aneffective instrument in the hands of government to obtain the desiredtargets such as level of output, unemployment, and prices. Therefore, itis very important to know whether changes in money supply cause changesin output or vice versa. In other words, we have to identify thedirection of the causality. If both variables are serially correlatedwith each other then we cannot use any of them as a determinant of theother.