Is there Causal Relationship between Money Supply Growth and Inflation in China? Evidence from Quantity Theory of Money

• Date: 01 August 2016
• DOI: http://doi.org/10.1111/rode.12194
• Published date: 01 August 2016
• Author: Chi‐Wei Su,Jiao‐Jiao Fan,Xiao‐Lin Li,Hsu‐Ling Chang

Is there Causal Relationship between Money Supply

Growth and Inflation in China? Evidence from

Quantity Theory of Money

Chi-Wei Su, Jiao-Jiao Fan, Hsu-Ling Chang, and Xiao-Lin Li*

Abstract

This study examines the causal relationship between Chinese money supply growth and inflation, using

the bootstrap Granger full-sample causality test and sub-sample rolling-window estimation test to

determine whether such a relationship in China supports the quantity theory of money. The result

indicates that there is a unidirectional relationship from inflation to money supply growth. However,

considering structural changes in two series, we find that short-run relationships using full-sample data

are unstable, which suggests that full-sample causality tests cannot be relied upon. Then, we use a time-

varying rolling-window approach to revisit the dynamic causal relationship, and the results show that

money supply growth has both positive and negative impacts on inflation in several sub-periods, and in

turn, inflation has the same effects on money supply growth for China. These findings are basically

consistent with the modern quantity theory of money from the perspective of money supply and price

level. When money supply growth does not outweigh output growth, inflation should not be curbed only

by decreasing money supply. It notes that a stable money supply growth is critical to price level stability

and economic development in China.

1. Introduction

The objective of this study is to test the causal relationship between money supply

growth and inflation in China and whether the quantity theory of money exists.

From the perspective of traditional quantity theory of money, the long-run

relationship between money supply growth and inflation is unity. The price level

changes with money supply movement in the same direction and proportion (Fisher

and Brown, 1911; Pigou, 1951). Friedman, as the representative of modern quantity

theory, believes that inflation occurs only when the money supply growth outweighs

output growth; in other words, if money supply growth does not exceed output

growth, it is unlikely to cause inflation (Friedman and Schwartz, 1963; Friedman,

1964, 1970). Price stability is one of the four goals of monetary policy. The ultimate

goals of monetary policy are price stability, full employment, economic growth and

balance of payments. The primary monetary policy objective of the People’s Bank

of China (PBOC) is keeping the price level stability. Meanwhile, the PBOC has

attached great importance to economic growth as well. The PBOC adopt

*Li (Corresponding author): Department of Finance, Ocean University of China, 238, Songling Road,

Qingdao, Shandong, China. Tel: +86-18562583085; E-mail: smileman2004@126.com. Fan and Su:

Department of Finance, Ocean University of China, Qingdao, Shandong, China. Chang: Department of

Accounting and Information, Ling Tung University, Nantun District, Taichung City, Taiwan. This

research is supported by the National Social Science Foundation (Grant No. 15BJY155), and Ministry of

Education’s Humanities and Social Science Research Project (Grant No. 14YJA790049). We want to

thank the editor and the reviewers for their constructive comments and suggestions on previous versions

of the manuscript. The usual disclaimer applies.

Review of Development Economics, 20(3), 702–719, 2016

DOI:10.1111/rode.12194

©2016 John Wiley & Sons Ltd

discretionary monetary policy requires that the monetary authority accord with the

economic situation through the use of various monetary policy tools to regulate the

money supply and credit and, hence, ensure economic growth while achieving price

stability (Zhang, 2009; Sun, 2013). Therefore, price level may not change with

money supply movement in the same direction (Sun and Ma, 2004; Liu and Jin,

2005; Chen et al., 2009). The link between inflation and money supply is always an

important issue in macroeconomics; a country’s money supply and inflation are

related to the primary macroeconomic variables (He, 2012). On the one hand, the

demand for money is the main factor that influences the level of commodity prices,

real disposable income of consumers and interest rates and other economic

variables, all of which represent the combined effect of a change in money supply.

On the other hand, the money supply also affects the domestic price level and

income, one of the main macroeconomic variables (He, 2012). Furthermore, the

relationship between money supply growth and inflation not only provides an

effective basis for the evaluation of the effectiveness of monetary policy decisions

but also suggestions for the prevention of a future inflationary foundation (Yang

et al., 2008; Zhou and Yang, 2014; Jiang et al., 2015).

China’s economic growth significantly decreases and the unemployment rate

continues to climb as a result of the 2008 financial crisis. To maintain economic

stability and continue the momentum of rapid development, the central bank of

China, the PBOC has implemented a moderately loose monetary policy since 2009.

As a consequence, the money supply in China surpassed that of Japan, the USA

and the Euro area to become the world’s largest “money machine” in 2009. In

2014, the PBOC indicated that the broad money supply (M2) came to US$20

trillion and the money supply growth rate was 14.7%, the highest in the world. As a

result, it is concerned that such striking money supply growth will bring substantial

inflationary pressures to the Chinese economy. Meanwhile, the National Bureau of

Statistics data show that consumer price index (CPI) year-on-year growth rose 2.0%

in 2014, a dramatic change in price level in China. Hyperinflation has a devastating

impact on economic development. If the quantity theory of money holds true in

China, high money supply growth would ultimately threaten future price stability

and economic growth. Therefore, we are greatly motivated to research the

relationship between money supply growth and inflation in China, with special

attention paid to testing whether the quantity theory of money works in China. We

also provide suggestions for the prevention of future rapid inflation; stable money

supply growth is critical to price level stability and economic development.

Substantial studies have been undertaken focusing on the relationship between

money supply and inflation over the past century. Fisher and Brown (1911), as the

representative of the traditional quantity theory of money, indicates that as the

monetary authorities increase the amount of currency (money supply) in the

economy, price level must increase in the same proportion, while the velocity and

quantity of goods remain unchanged. Keynes (1936) indicates that under the

condition of purchasing power in which the monetary form held in the hands of

people is constant, prices will rise or fall in proportion to the number of

government issuing notes. Friedman and Schwartz (1963) attributes inflation to

currency factors and indicates that money supply exceeding money demand causes

and exacerbates inflation (rising prices) and that this is always just a monetary

phenomenon. Lucas (1972), as the representative of the Rational Expectation

Hypothesis, finds that people’s expectations are rational, and thus, changes in the

money supply in the short term are reflected in prices. Dewald and Gavin (1981)

MONEY SUPPLY GROWTH AND INFLATION IN CHINA 703

©2016 John Wiley & Sons Ltd