Money supply, employment and national income causality: the Turkish experience

Abstract

The role of monetary policy in economic growth has long been a subject of under debate between Keynesians and Monetarist Schools of economic thought. Early Keynesian economists did not have any role for money supply in the economy since they did not have a theory of inflation for situations of less than full employment. Thus, in the 1950’s the Keynesian consumption function model did not include money supply and prices or the price levels as explanatory variables. As Landreth and Colander stated (2002), this initial lack of concern about money supply and prices manifested itself in policy based on Keynesian analysis; for example, money supply was used as an instrument to hold the interest rate constant. According to Keynesians, the transmission mechanism between increases in the money stock and the level of nominal income is indirect, operating through the rate of interest. Thus, according to Keynesians, the role of money in income generation operates passively through interest rate channel. In the Keynesian model, prices are assumed to be fixed in the short-run, so an increase in the nominal money supply means an increase in the real money supply. The real interest rate decreases due to the increasing money supply, because wealth owners exchange their money for nonmonetary assets. The purchase of nonmonetary assets drives up their prices, which is the same as decreasing the real interest rate that they pay. Also, the lower real interest rate stimulates both consumption and investment spending. With more demand for their output, firms increase employment and production. The effect of an increase in money supply can also be evaluated within the Keynesian version of the investment-savings (IS) and liquidity preference-money supply (LM) model (IS-LM model). According to the IS-LM model, an increase in money supply brought about by open-market purchases of bonds by the central bank will shift the LM curve to the right and induce a movement along the IS curve so that real interest rate declines and output increases. At the initial interest rate and output, with the increase in money supply, individuals can have excess money and they attempt to buy bonds with this excess money. As a result, depending on increasing demand for bonds, bond prices increase and interest rates fall. Similarly, the lower real interest rate increases both consumption and investment spending, which in turn drives up output and income. If the money supply is constant, the increase in income increases the demand for money and accordingly the money supply increases. In the Keynesian model, the direction of causation runs from income to money, meaning that changes in income cause changes in money stocks via demand for money. On the other hand, there is price rigidity in the short-run in the Keynesian model, if there is a monetary expansion, this will cause real interest rates to fall and employment and output to increase. Hence, interest rates play a crucial role to determine the new equilibrium. Thus, the direction of causation runs from money to income via real interest rate. As a result, according to the Keynesian model, there is a bilateral causality between money supply and income in the short-run....