Causality between Money and Prices: Evidence from Pakistan

The relationship between money and prices has been a debated issue among economic schools of thought particularly between the Monetarists and the Keynesians. The monetarists claim that changes in money stocks cause changes in price levels. In other words, the direction of causation runs from money to prices implying that prices can be controlled through money supply. The keynesians, on the other hand, argue that money is important but is not responsible for changes in price levels. Instead, structural factors play important role suggesting that money supply is not an effective instrument to control price changes. The causal relationship between money and prices has been extensively tested in various countries. For example, Brillembourg and Khan (1979) examined this relationship in USA. Using Sims procedure for the period 1870-1975, they found unidirectional causality running from money to prices. Similar directions of causation are reported by Lee and Li (1983) and Ramachandran and Kamaiah (1992) who investigated the causal relationship in Singapore and India respectively. On the other hand, Aghevli and Khan (1978), while investigating the causal relationship in Brazil, Columbia, the Dominican Republic, and Thailand, found bidirectional causality between money and prices in these countries.