SBP Working Paper Series STATE BANK OF PAKISTAN

2.1 Monetary Aggregates and Economic Activity
The most straight forward observation regarding the relationship between monetary aggregates 7 and GDP
is that both nominal and real monetary aggregates are strongly procyclical at levels. The first two rows of
scatter plots in Figure 1 and Figure 2 depict a clear positive relationship between monetary aggregates and
GDP. The growth rate of monetary aggregates do not reflect a significant co-movement with GDP (3rd
rows of scatter plots in Figure 1 & 2).
Similarly the real and nominal monetary aggregates at levels depict positive co-movement with LSM
(Figure 3 & 4, row 1 & 2) whereas there is no clear link between monetary aggregate growth rates and
LSM. The only exception is the annual M2 growth rate that shows slight positive co-movement with LSM
(row 3 in Figure 3). These observations give confidence in quarterly GDP to use as a proxy of economic
activity.
The contemporaneous correlations presented in Table A1 confirm these findings by showing that
correlations of monetary aggregates with GDP and LSM are positive and statistically significant.
In order to better understand this strong pro-cyclical behavior of monetary aggregates, we try to
investigate the direction of causation. The dynamic correlations between GDP and different lags of
monetary aggregates (left panel of Figure 7A) are positive. This means that current GDP is positively
associated with lagged monetary aggregates; indicating a leading indicator role being played by money.
On the other hand, different leads of monetary aggregates also show positive correlations with GDP
pointing out that higher income also causes higher money demand.
The dynamic correlations between monetary aggregates and LSM also show similar phenomenon as
shown by the left panel of Figure 7B. The positive correlations at both leads and lags indicates two-way
causality between money and economic activity.
The Granger causality test results presented in Table A2 and A3 seem to further endorse this two-way
causality proposition. The nominal and real M1 and M2 Granger cause GDP and are Granger caused by
GDP in the quarterly data (see Table A3). In annual data, real M1 and M2 show two-way Granger
causality with GDP. The nominal monetary aggregates show a mixed pattern of causality in annual data;
M1 causes GDP and M0 is caused by GDP. However, the growth of monetary aggregates seems to settle
the issue of direction of causality. In quarterly data, growth of M1 and M2 Granger causes GDP whereas
the converse is true in the annual data. This observation signals that in short run, monetary aggregates
fluctuations cause fluctuations in GDP whereas in medium run (annual data) they are caused by GDP
fluctuations.
In order to establish robustness of above mentioned relationships over time, we compare dynamic
correlations calculated using full sample period (1990Q1-2012Q4) with the ones calculated using sample
period 2000Q1-2012Q4. For the two sample periods, dynamic correlations of GDP and LSM fluctuations
with leads and lags of monetary aggregates seem to preserve their overall shape (left panels in Figures 7A
and 7B) and reflect a slight increase in magnitude in the recent time. This indicates that sensitivity of
7 In our empirical analysis, averaging method was used for adjustment of outliers in the series of M0 in 2001q2 and 2009q2, M1 in 1998q1, q3 &
q4, 2004q1 & q3 and M2 in 2004q1 & q3. The series of M1 was adjusted for change of definition of demand deposits using splicing method from
2007 onwards.
7