Effects Of Monetary Policy On Economic Growth Of SAARC Region

This research aims to explore the rapport between monetary policy and economic growth.This study provides outcomes for the effect of monetary policy on economic growth by using different econometric approaches.First,descriptive analysis for each variable is provided.Further,these outcomes are obtained using Cross-section dependence test,Slope homogeneity test,first and second generation panel unit root tests,Westerlund(2007)panel cointegration approach,cross-sectional augmented autoregressive distributed lags(CS-ARDL)model.Moreover,for robustness analysis,augmented mean group and common correlated effect mean group tests are used.For transmission mechanism,variance decomposition approach is used.Policy suggestions are made.The sampled area of this research is South Asian Association for Regional Cooperation(SAARC)comprising Pakistan,Bhutan,Maldives,Bangladesh,Nepal,Sri Lanka,Afghanistan and India from 2000-2018.For monetary policy measurement,we used broad money(M2)and for economic growth,gross domestic product is used.Other controlled variables like human capital which is measure through an index,trade openness which is measured as the sum of imports and exports to GDP and real interest rate are used.This study concentrates on the interactions between money supply,real interest rates,inflation and economic growth.The issue of possible nexus between monetary policy and output growth has been intensively investigated in the literature with contradictory evidences.However,the previous literature focused on the direct linkage by explicitly assumes homogeneity of socioeconomic indicators.This study is different from the existing studies as it this study examines the indirect effects of monetary policy on output growth.Moreover,this study examines the transmission mechanism of monetary policy.The previous work of monetary policy is greatly criticized on the ground of unconditional model specification.This study contributes to the existing literature by assuming the direct rapport between variables.This study examines the indirect effects of monetary policy in case of SAARC countries,which has not been investigated so for.Moreover,the study uses advance dynamic panel data techniques to investigate the issue under consideration.This empirical research uses several econometric approaches to acquire the results.For unit root test,Levin,Lin and Chu,Breitung,Fisher-AD and PP test,Im,Pesaran and Shin test and cross-sectional augmented Im,Pesaran and Shin test are used.For,cross-section dependence and slope heterogeneity,Pesaran(2004),Pesaran and Yamagata(2008)tests are used.Westerlund(2007)cointegration test is applied for cointegration relationship.Moreover,cross-sectional augmented ARDL test is used for short-run and long-run results.The robustness of results is checked by using augmented mean group(AMG)and common correlated effect mean group(CCEMG).The results found mixed order of integration with the existence of the problem of heterogeneity and cross-section dependence.The Westerlund(2007)cointegration test confirm long-run cointegration relationship among all the variables.For the long-run and short-run,broad money,trade openness and human capital is supportive in improving economic growth in case of South Asian Association for Regional Cooperation(SAARC).However,in contrast,real interest rate is declining economic growth.These results confirm that increasing broad money along with human capital and trade openness improve economic growth.While,high real interest rate may crowd-out investment and which in turn lower economic growth.This study uses the annual data for SAARC countries over the period of 2000 to2018 in order to investigate the effects of monetary policy on economic growth after controlling for trade openness,human capital and real interest rate.A debate on the significance of using Co-integration and Error Correction Mechanism(ECM)as empirical tools stated among researchers and policy makers,a question arises on the applicability of these two methods for stationary data.Arguments given in favor of error correction mechanism included;the origin of this method,which dates back before the Co-integration method was introduced.In this paper,Westerlund(2007)co-integration and CS ARDL methods are used that can assess the effect of monetary policy on the economic growth.Hence a tool is provided that can be used to analyze the dynamics of the relationship between monetary policy and economic growth of SAARC countries.However,before using cointegration techniques,it is necessary to apply cross sectional dependency and slope heterogeneity tests.The efficacy of monetary policy in SAARC countries are largely attributed to the socioeconomic indicators in these countries.Generally,SAARC countries have weak financial system and undeveloped human capital.Despite this,there is heterogeneity in the monetary policy growth nexus in SAARC countries.It shows countries such as Bhutan,Afghanistan are concentrating on very high interest rate while countries such as Nepal,Pakistan and Sri Lanka have low interest rates over the period of 2000 to 2018.Itis evident from the mean values that Maldives is the most open economy as its trade openness as a percent of GDP is 76.67.As for as human capital is concerned,Sri Lanka is top in the list.Economy's role in the 21 st century is utmost important.It is,as important as,blood in the veins,power in the muscles.It is the ground for different governments to rule.The stronger the economy is,the more powerful will be the nation.The economies of SAARC countries have been passing from different phases.SAARC countries secure good position on the basis of geography.Being the poor countries,SAARC countries are full of unexplored natural resources and has acquired abundance of labor.Inflation rate in SAARC countries are very high over the period of time.Global financial crises have made threaten SAARC,and also compelled foreign investors to run away.Instability has been flowing.It is clear from the history that civilians go for protest,if government doesn't deal economic issues with ability.Military sometime takes over,if government goes awkward,and is cleared from history.Due to rise in global connectivity and economic integrations,countries around the globe are interconnected with each other on multiple fronts.No single country is self-sufficient and isolated from the rest of the world.The global production chain is interconnected and countries are much dependent upon each other in terms of production,international trade,investment etc.Similarly,global and local shocks to an economy may not only affect single economy but it shall also have spillover effect on other countries.Therefore,by assuming independence for cross-section is a very bold assumption and in the current age it is difficult to see such situation.Therefore,it is important to check for cross-section dependence first before using further econometric approaches for empirical results.Monetary policy is a tool of macroeconomic stability and the both developed and developing world is utilizing it to achieve stability.Economic growth and development are the foremost objective of economic policy.In general,long run policies are advocated and implemented to achieve this economic objective,but it is difficult to achieve this core objective without maintain economic stability.Hence,economic stability is the pre-condition for the attainment of economic growth and development.Therefore,utilization of human,financial and physical resources and capital to get the prospective economic growth and development without focusing macroeconomic stability may result in allocative,distributive and productive inefficiency.Moreover,it is also associated with other economic problems such as missing the potential output and employment in agricultural,industrial and services sectors that could be achieved if monetary policy to get macroeconomic policy were implemented parallel to development policies.Theultimate objective of macroeconomic policies is to enhance economic growth and stabilize the price level.Monetary policy is designed to achieve these goals.Monetary policy plays a vital part in affecting economic growth,price stability,exchange rate stability,and employment level,balance of payment and economic development of a country.During the period of slow economic growth and rising unemployment central bank will tend toward soft monetary policy stance to enhance aggregate demand.Positive growth in aggregate demand will then increase productive potential of the economy and thus employment growth will be achieved.On the other hand,if the economy is experiencing period of inflationary pressure policy makers will attempt to mitigate this pressure with help of tight monetary policy to control the aggregate demand to put the economy on the expansion path.However,these monetary measures are subject to certain constraints and uncertainties as the policy makers do not have full information the behavior of the economy such as the actual position of aggregate demand and other relevant macroeconomic variables,in particular the lag effect of some monetary variables.However,the widespread income differences across countries led to extensive research on economic growth and its determining factors for the last several decades.The center theme of the study is economic growth,inflation,and monetary policy.Nevertheless,the researchers are not agreed to a common conclusion regarding the policy instruments which explain the monetary policy transmission apparatus efficiently.The rapid changes in the monetary policy theories over time have attracted the researchers to probe the dynamic effects of monetary policy on growth and other macroeconomic activities.).However,the widespread income differences across countries led to extensive research on economic growth and its determining factors for the last several decades.The center theme of the study is economic growth,inflation,and monetary policy.Nevertheless,the researchers are not agreed to a common conclusion regarding the policy instruments which explain the monetary policy transmission apparatus efficiently.The rapid changes in the monetary policy theories over time have attracted the researchers to probe the dynamic effects of monetary policy on growth and other macroeconomic activities.All the main sources in a country that can be utilized to stimulate growth are affected by money supply as,indicated in the discussions regarding policy and theory.Two arguments are particularly found to support the theory;that money supply impacts the economic growth through capital accumulation.They suggestthat lower accumulation of capital leads to non-linear impact of money supply on the process of economic development and expansion.First argument is an interest rate channel,which implies that the accumulation of capital stock slows down because investors are discouraged to invest in a country,rapidly increasing sluggishness of economy.Investors are discouraged due to the anticipation that;an increasingly money supply will compel the government to borrow and impose progressive and aggressive taxes.The second argument is the anticipation of investors about the proportion of government borrowing due to increase in money supply to be serviced with the domestic resources such as bank and non-bank borrowing.This anticipation makes the investors hold back their investment in the increasingly indebted country.Other than low accumulation of capital stock,lower growth in factor productivity,driven by high indebtedness is also regarded as an obstacle in the economic growth of indebted country.For example,such costly and difficult policies,which majorly facilitate and provide enormous profits to the foreign creditors,are less likely,to be favored by the government.Long run productivity growth is driven from such investment that involves high risks and is a long-term,rather than the short-term investment that provides quick returns.The uncertain economic environment of indebted countries is inappropriate for long-term investments involving high risks.Thus,slower growth in productivity is contributed by reduced efficiency of investment projects and misallocation of resources.Those who advocate expansionary monetary policy,often argue that,education,health,infrastructure,energy,and other social services are inefficiently and sometimes not at all provided in countries with strict monetary policies.Anticipated increase in money supply and inflation have adverse impact on the investment decision,one of which is the acquisition of human capital.Therefore,low level of money supply slows down the process of economic growth through low accumulation of capital.On the other hand,the long run impact of money supply on capital accumulation has been made the detection of this channel exceedingly difficult.Macroeconomic instability is related to the anticipated inflation,possible monetary expansion,depreciation in the exchange rate and exceptional financing resulting in uncertainly and rise in fiscal deficit.A reliable estimate of the money supply is an important sign of the Gross Domestic Product(GDP)and many other macroeconomic indicators.Monetary authorities are required to know whether there will be enough money supply to fulfil the demand of economic agents like individuals and investors.An accurate prediction of the supply of money provides the policy makers a consistentinstrument for following and forecasting interest rates.In recent years,the issue of possible effectiveness of monetary policy in affecting growth and other macroeconomic activities has been intensively investigated in the literature with contradictory evidences.Monetary easing resulting in more money supply or monetary tightening leading to less money supply is also supposed to be affected by GDP.Consequently,a single equation method of estimation will provide parameters that would be biased and inconsistent.Error correction models of dynamic econometric equations impose testable and strong non-linear restrictions.Also,there is no obviation of the need of modelling the process of expectations formation,if the dynamic econometric equations are represented as error correction models.Whenever ECMs are treated as mere re-parameterization of vector auto regression or dynamic linear regression models,it results in ignorance from the modelling of expectations and the non-linear restrictions except in some special cases.The objective of the paper is to estimate income-money supply model for SAARC countries over the period of 2002 to 2018.The literature in the introduction section suggests there is endogeneity problem in estimating money supply and income relationship.Therefore,to estimate the parameters of income-money supply model,we use the recently developed econometric techniques to handle the problem of endogeneity.To test the relationship between M2 and GDP in case of SAARC countries,first step of our methodology is to apply Hausman specification test to find the presence of simultaneity between GDP and M2.In the second step we utilize cross sectional dependency test.Then we apply appropriate cointegration method based on the identified equation.The previous literature regarding the monetary policy and economic growth mainly focused on the nonlinear model specifications.The basic purpose was to estimate the direct effect of monetary policy on economic growth.In recent years,the researchers are concentrating on nonlinear model specification in investigating the relationship between different set of variables.Many researchers have studied the monetary policy by using different approaches and still the process is continued.The existing studies had some methodological issues and their conclusions fails to make a decision about the response of money to economic activity.It is difficult to identify how differences in statistical actions influence these results.India has the highest value of broad money as percent of GDP from 2000 to 2018.This indicates that India has concentrated on expansionary monetary policy over the years.Moreover,Afghanistan has the lowest value of broad money as percent of GDP from 2000 to 2018.This is might be due to the unprecedented war in the country.The linkage between money supply and real GDP isobvious from the table.India has the largest money supply and real GDP,while Afghanistan has the lowest money supply and real GDP.If we concentrate about some numerical values on SAARC region countries especially on average,Sri Lanka has the highest value of human capital,which is due to their exceptional literacy rate.On the other hand,Afghanistan has the lowest value of human capital from 2000 to 2018.As for as trade openness is concerned,Nepal is the most open economy in the study period.On average the trade openness as percent of GDP for Nepal is 76.67.On the other spectrum,Bangladesh is the closest economy.On average the trade openness as percent of GDP for Bangladesh is 15.87.As for as interest rate is concerned,Bhutan has the highest interest rate in the study period.On average,the real interest rate in Bhutan is 9.27%.Moreover,Nepal has the lowest interest rate in the study period.On average,the real interest in Bhutan is 2.72%.The largest economy is India with real GDP of 165268.41 Billion in Indian rupees,while Afghanistan is the smallest economy with 1392.41 billion local currency.Human capital for SAARC countries over the period of 2000 to 2018.Broad money as a percent of GDP for SAARC countries over the period of 2000 to 2018.Maldives has the highest money supply as percent of GDP.The upward trend in broad money as a percent of GDP is evident for all SAARC countries over the time.Sri Lanka is the most developed country in human capital as compare to other SAARC countries.This is due to their extra ordinary performance in education sector.The literacy rate of Sri Lanka is highest among SAARC countries.Trade openness as a percent of GDP for SAARC countries over the period of 2000 to 2018.Nepal is the most open economy as compare to other SAARC countries.The real interest rate for SAARC countries over the period of2000 to 2018.There are fluctuations in interest rate over the study period.Starting from the highest interest rate in 2000,Maldives reaches to lowest interest rate in 2018.The importance of the money supply in affecting the output and employment is a debatable issue.The heritage of this debate lies in the idea of famous quantity theory of money.However,Keynes criticized the theory on the ground of weak assumption of full-employment level of output.Hence,changes in money supply can affect the real output because the economy is operating at less than full employment.Moreover,Keynes argued that money supply affects price level through interest rate channel.Changes in interest rate are associated with capital mobility,investment and output and ultimately price level.However,in liquidity trap,monetary policy becomes ineffective.Later on,in1950 s,monetarists contributed to this proposition by arguing that money supply is themain instrument through which macroeconomic activities can be affected.According to Freidman,money matters and changes in money supply has impact on real as well as nominal output of the economy.Nevertheless,money supply affects the real variables only in short-run.Monetarists predicts non-neutrality of money in the short run.However,the preposition was rejected by the modern classical school of macroeconomics in the1970 s.Data for this study is collected for 18 years starting from 2000 till 2017.The time period for data is decided due to possible available data for different countries.The list of variables and its definitions are first gross domestic product(GDP)it is the final value of all the goods and services produced within the boundaries of a country during a definite period of time.It is measured in constant US dollars 2011.Although GDP is frequently calculated on an annual basis,it can be calculated on a quarterly basis as well.In America,for instance,the government releases an annualized GDP estimate for each quarter and also for an entire year.Most of the individual data sets will also be given in real terms,meaning that the data is adjusted for price changes,and is,therefore,net of inflation.Broad money(M2)this measure currency including demand deposits,outside banks,foreign,savings,time currency deposits.It also covers travelers and banks checks and other securities like commercial paper and certificates of deposit,human capital index(HC)it measures not only labor market information but also the returns estimated to education,Human capital is an intangible asset or quality not listed on a company's balance sheet.It can be classified as the economic values of a worker's experience and skills.This includes assets like education,training,intelligence,skills,health,and other things employers value such as loyalty and punctuality.The notion of human capital distinguishes that not all labor is equal.But companies can improve the quality of that capital by investing in personnel the instruction,knowledge,and skills of staffs all have economic value for companies and for the economy as a whole.Human capital is significant because it is perceived to increase output and thus effectiveness.So the more a company invests in its employees(i.e.,in their training and knowledge),the more productive and profitable it could be.A company is often said to only be as good as its people managers,staffs,and leaders who make up a company's human capital are important to its success.Human capital is usually managed by a company's human resources(HR)department.This department manages staff achievement,administration,and optimization.Its other directives include labor force planning and strategy,employment,worker training and development,and reporting and analytics.Human capital tends to migrate,especially in global economies.Therefore often people ofdeveloping countries migrate to developed countries.Some economists have called this a brain drain,making poor places poorer and rich places richer.Trade openness(TO)measures the openness of a country to trade.It sums imports and exports over to GDP and another explanation of trade openness is a measure of economic policies which either limit or extent trade among countries.For instance,if a country sets a policy of high trade tariffs,it means that country limit the attractiveness of global trade,this policy cause other countries to export and accepting imports from that country.According to dominating economic theory,this limitation,will have bad result on development of an economy.On the other hand,according to economic theory,trade openness has good effect on development of a country.Real interest rate(RIR)it is the interest rate on lending that is adjusted for inflation.It is believed that the financial system has a vital role in the growth of economic for the long-run economic growth of a country.By implementing macroeconomic policies,the government facilitates this economic situation including fiscal and monetary policy.Fiscal policy talks about expenditure and revenue of government and monetary policy talks about money supply,interest rate,credit allocation and exchange rate.The financial systems in South Asia are not developed.While some countries in this region have good financial institutions,many countries' financial systems still remain undeveloped.India has a developed capital market,with extremely sophisticated stock exchanges,clearing corporations,depositories and derivatives markets.Pakistan also has advanced financial markets.However,other countries in the region,such as Bangladesh,Bhutan,Maldives and Afghanistan,are still at first stages of developments of their capital markets.The size of financial assets such as government securities,treasury bills,industrial bonds and readily marketable shares is usually is not good enough in these countries.There is a specific organization in SAARC region and it's called,SAARC FINANCE Network and was formed in 1998.The objectives of this regional network are to a)encourage cooperation among central banks and finance ministries in SAARC member countries through staff visits and regular exchange of info,b)study and suggest coordination of banking regulations and performs within the region,c)work on a more effective payment system mechanism within the SAARC region and try for closer monetary and exchange cooperation,d)forge closer teamwork on macroeconomic policies of SAARC member states and share experiences and ideas,e)study international financial developments and their influence on the region including negotiations relatingto emerging issues in the financial construction,IMF and World Bank and other global lending agencies,f)display reforms of the international financial and monetary system and to evolve a agreement among SAARC countries in respect of the reforms,g)evolve,whenever feasible,joint strategies,plan and mutual approaches in global opportunities for mutual benefit mainly in the context of liberalization of financial services,h)assume training of staff of the ministries of finance,central banks and other monetary institutions of the SAARC member countries in subjects connecting to economics and finance,i)discover networking of the training institutions within the SAARC region concentrating in several aspects of monetary policy,exchange rate reforms,bank supervision and capital market issues,and j)encourage investigation on economic and financial matters for the common advantage of SAARC member countries and study any other matter on the direction/request of the SAARCFINANCE,Council of Ministers or other SAARC bodies.Finance is the central point of an economy,where investments and saving are its tubes and vessels.Hence,a solid financial system is an important feature of stable economy.Financial system live long if it's basis is strong and survives in the people of grass-root level and these people live in villages and small cities,earn little salary,work in primary area,spend more on food,and have smaller social securities.In this setting,the process of bringing these kind of people into financial activities is called financial inclusion,Financial inclusion try to provide formal banking services to all the people of a society even the poorest people,now the vital aim of monetary policy is to make the most of social welfare by keeping low inflation rates and a steady output gap.The financial crisis,has caused that monetary policy as an instrument to control only inflation,financial stability is another objectives of monetary policy.Although SAARC countries are largely immune to the financial crisis,they cannot be immune to developments after the financial crisis due to monetary policy and the role of the central bank.One particular area which wants attention in SAARC central banks is the characteristic of intermediate target pursued by them.Still,many of them are targeting exchange rate or the monetary aggregates to reach price stability.In addition,some are following many objectives.Monetary targeting regime has frequently been desolated globally because of its natural weaknesses.Furthermore,diversity of objectives weakens accountability and therefore decrease credibility of the central bank.This is an area where the central banks of SAARC countries can pursue help from fellow countries who have recently left these kinds of regimes.At a larger level,making monetary policy more productive,needs the design of goals which are narrowly connected with each other andare manageable.This requires a comprehensive knowledge of the monetary policy transmission mechanism.Unluckily,none of SAARC country have done any research in this area,which is an area where the SAARCFINANCE forum can once again be used to start a study on evaluating the monetary policy transmission mechanism.Finally,to enhance the reliability of the central banks the legal and institutional framework of SAARC central banks need consideration.All the SAARC central banks have shortages in terms of independence,accountability and transparency.To make central banks more independent,first significant condition is to remove the path of debt monetization by the government.Second,the decision making authority for monetary policy must be free from the impact of the government.To improve accountability,central banks must report to the parliament directly and to bring transparency,minutes of the monetary policy meetings must be made public.