The effect of money growth on inflation in vietnam from 2004 to 2010

If money growth does affect inflation in Vietnam, monetary policy becomes a powerful policy for the government to maintain inflation at its target level.. However, there is few studies e

VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE EFFECTS OF MONEY GROWTH ON INFLATION IN

VIETNAM FROM 2004 TO 2010

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By BUI DINH PHUONG THAO

Academic Supervisor:

NGUYEN VAN NGAI

CONTENTS

CHAPTER 1: INTRODUCTION !

1.1 PROBLEM STATEMENT 1

1.2 RESEARCH OBJECTIVES AND QUESTIONS .3

1.3 METHODOLOGY 3

1.4 STRUCTURE OF THESIS 4

CHAPTER 2: LITERATURE REVIEW 6

2.1 THEORETICAL LITERATURE 6

2.1.1 INFLATION 6

2.1.2 SOURCES OF INFLATION 7

Keynesian View 7

Demand-pull inflation 11

Cost-push or structuralist inflation 13

Monetarists View 15

2.1.3 MONEY GROWTH 17

2.2 EMPIRICAL LITERATURE 21

2.3 AN OVERVIEW OF VIETNAM INFLATION AND MONEY GROWTH FROM 2000 TO 2010 29

2.3.1 INFLATION 29

2.3.2 MONEY GROWTH 31

2.4 CHAPTER REMARK 32

CHAPTER 3: RESEARCH METHODOLOGY, MODEL SPECIFICATION AND DATA SOURCES 34

3.1 ANALYTICAL FRAMEWORK 34

3.2 MODEL SPECIFICATION 35

3.3 DATA SOURCES 42

3.4 ECONOMETRICS TECHNIQUES .42

3.4.1 STATIONARITY AND UNIT-ROOT TEST .42

3.4.2 COINTEGRATION 44

3.4.3 ERROR CORRECTION MODEL (ECM) .47

3.4.4 SHORT-RUN CAUSALITY TESTS .49

Granger causality tests 49

Variance decomposition 51

Impulse response function 51

CHAPTER 4: THE EFFECTS OF MONEY GROWTH ON INFLATION IN VIETNAM FROM 2004 TO 2010 52

4.1 DESCRIPTIVE STATISTIC 51

4.2 ECONOMETRIC RESULTS , 54

4.2.1 UNIT ROOT TESTS , 54

4.2.2 BIVARIATE TESTS , 55

Engle-Granger cointegration tests 55

Error correction model 56

4.2.3 MULTIVARIATE TESTS 51

Johansen cointegration tests , 57

Vector error correction model (VECM), Granger causality tests, variance decomposition and impulse response function 59

4.3 MODEL FORECASTS 66

4.4 RESULTS COMPARISON 66

4.5 CHAPTER REMARK 70

CHAPTER 5: CONCLUSIONS AND POLICY IMPLICATION 73

5.1 CONCLUSIONS 73

5.2 POLICY IMPLICATION 74

5.3 LIMITATION 76

REFERENCES

APPENDIX

LIST OF TABLES

Table 3.1: Variables Description, Expected Signs and Data Sources 36

Table 4.1: Description of Variables 52

Table 4.2: Correlation among Variables 54

Table 4.3: Unit Root Tests Results 54

Table 4.4: Unit Root Tests for Residual ofCPI and M2 55

Table 4.5: Error Correction Model 56

Table 4.6: Johansen's Cointegration Tests With 9 Lags 58

Table 4.7: Granger Causality Tests: P-Values For The lTests 60

Table 4.8: Variance Decomposition ofCPI (Order Reflects Cholesky Ordering) 62

Table 4.9: The Thesis' Results in Comparison with Empirical Studies' Results 67

• LIST OF FIGURES Figure 2.1: The Long-Run Macroeconomic Equilibrium 9

Figure 2.2: Recessionary and Inflationary Gap 1 0 Figure 2.3: Government Intervention When Recessionary Gap Occurs 10

Figure 2.4: An Increase In Aggregate Demand 12

Figure 2.5: Demand-pull Inflation Spiral 13

Figure 2.6: An Increase in Short-run Aggregate Supply 14

Figure 2.7: A Cost-push Inflation Spiral 14

Figure 2.8: CPI in December and Average CPI from 2001 to 2010 31

Figure 2.9: Broad Money Growth From 2002 To 2010 32

Figure 3.1: Analytical Framework 34

Figure 4.1: Impulse Response Functions 65

•

CHAPTER 1: INTRODUCTION

This chapter will explain the importance of this thesis, its objectives and research questions In addition, a brief of methodology is also mentioned in this part Finally, the structure of thesis will be presented

l.lPROBLEM STATEMENT

Money plays important role to the economy Greco (200 1) suggested money has five functions which are "a medium of exchange, a standard of value, a unit of account, a store of value and a standard of deferred payment" As a medium of exchange, money helps to divide the goods exchange process into two separate parts which are purchase process and sales process Therefore, people can buy goods at different places and sell goods in different time; hence money promotes trading activities Furthermore, money is used as standard to measure and present value of goods as well as prices of goods It extremely supports business to quote and record costs, products' prices and calculates value of gross domestic products (GDP), gross national products In addition, money is preferred to keep for future consumption and prevent risks As a standard of deferred

increases the liquidity of debts, thus supports businesses and economic growth

Based on its importance to the economy, money growth can affect the economy in many channels People receiving more money are willing to consume more, thus it stimulates consumption and encourages imports More money means more capital to make investment in order to expand companies' business Besides, growth in money supply will sponsor government's expenditure and decrease governmental budget deficit Consequently, an increase in money stock may lead to growth in aggregate demand and positively affect the economy On the other hand, high growth in money may reduce its

value and cause an increase in price level Monetarists suggested that money is the main determinant of inflation while Keynesian views argued money which leads aggregate

• demand to exceed aggregate supply is only one of determinants of inflation However,

Mishkin (1995) concluded that both monetarists and Keynesians believed that high inflation only possibly occurs with high money growth rate

There are also a majority of empirical studies examining the effects of money growth on inflation Several studies suggested that money supply significantly positively influences inflation such as Moroney (2002), De Grauwe and Poland (2005), Thornton (2008), Kaufmann and Kugler (2008), Gingting and Bird (2009) and Basco, et al (2009) In contrast, some papers, for example Fie (2003), argued that the effects of money growth

on inflation is insignificant In case of Vietnam, there are different findings regarding the dependence of inflation on money supply According to Baker, et al (2006), Goujon (2006) and Thanh (2008), money positively impacts price level On the other hand, a research of Hung and D Pfau (2008) pointed out this effect is unobvious

In addition, according to the Vietnam's Prime Minister Nguyen Tan Dung (2011), the primary goals of the government at present are to stabilize macroeconomic and to control inflation at an appropriate level If money growth does affect inflation in Vietnam, monetary policy becomes a powerful policy for the government to maintain inflation at its target level However, there is few studies examined and quantified the effects of money growth on inflation in Vietnam in order to define the level of increases in money supply to meet the target inflation Therefore, this thesis aims to not only examine the influence of money growth on inflation but also estimate the level of money growth to achieve the expected inflation of the Vietnamese government in 2011

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1.2 RESEARCH OBJECTIVES AND QUESTIONS

Analyzing the impact of money supply on inflation is extremely important for the

• government to conduct an appropriate monetary policy Therefore, this thesis aims to

examine the effects of money growth on price level in long-run and short-run in Vietnam

In order to meet this overall goal, the research will obtain following objectives:

(i) Analyze the effects of money growth on inflation in Vietnam in long-run

(ii) Analyze the effects of money growth on inflation in Vietnam in short-run

(iii) Advise the level of money growth to meet the target inflation of the Vietnamese government in 20 11

The research questions are proposed:

(i) Does money affect inflation in Vietnam in long-run?

(ii) Does money affect inflation in Vietnam in short-run?

(iii) Which level of money growth does meet the target inflation m 2011 of Vietnam's government?

1.3METHODOLOGY

In order to examine the dependence of inflation on money growth in Vietnam in long-run and short-run, monthly data from December 2003 to June 2010 are collected from International Monetary Fund and Vietnam General Statistics Office The research will employ descriptive statistics and econometric techniques

Descriptive analysis will firstly give a summary of all variables to provide an overview of data collection such as their distribution, central tendency and variation Then the correlation matrix will suggest the potential relationship between each pair of variables

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In addition, the unit root tests are used to test for stationary of all variables to ensure the validation oft-tests and F -tests After that, four econometric techniques will be applied in this thesis in order to examine the long-run and short-run effects of money growth on inflation

Firstly, to investigate the long-run influence of money growth on inflation to answer the first research question, the Enge-Granger cointegration test and error correction mechanism (ECM) are employed

Secondly, the thesis will add other determinants of inflation into a model with money growth then apply the Johansen co integration tests to re-test the effects of money growth

on inflation in long-run and confirm the number of co integration equations

After that, in order to answer the second research question, vector error correction model (VECM), Granger causality tests, variance decomposition and impulse response functions are used to examine the short-run impact of money on inflation

Finally, a level of money growth is forecasted by applying VECM to meet the target inflation level of the Vietnamese government in 2011 to answer the third research question

1.4 STRUCTURE OF THESIS

The thesis consists of five chapters

Chapter 1 presents the important of the thesis' findings and its objectives It also briefly presents the methodology is applied in the thesis

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Chapter 2 demonstrates the literature review It starts with definitions of money growth and inflation Then the chapter focuses on Keynesian views and the quantity theory of money After that, empirical studies regarding the effects of money growth on inflation are introduced An overview of inflation rate and growth in money supply in Vietnam from 2000 to 2010 is also presented in this chapter

Chapter 3 is based on theories and empirical research to present an analytical framework then develop a model explaining inflation in short-run in Vietnam This chapter will mention data sources as well as economic techniques used in the thesis

Chapter 4 presents results of hypotheses testing and suggests the level of money growth

to achieve the target inflation ofVietnamese government in 2011

Chapter 5 will give the conclusion, policy implications and suggest for further studies

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CHAPTER 2: LITERATURE REVIEW

This chapter will briefly describe the definitions of inflation and money supply In addition, theories which are applied in this thesis are introduced After that, the thesis will present empirical studies' results regarding the effects of money growth on inflation in other countries and in Vietnam Finally, a summary of inflation growth and money growth in Vietnam from 2000 to 2010 is given to have an overview about inflation and money supply in Vietnam in this period of time

2.1 THEORETICAL LITERATURE

2.1.1 INFLATION

Inflation is a term to indicate the continuous growth in price level over a period of time

In the words of Ackley (1978) "inflation may be defined as a persistent and appreciable rise in general level of average of price" Mankiw (2002) defined inflation is as "an abnormal increase in the quantity of purchasing power" According to Pi ana (200 1 ), there are four types:

percentage points and an explosive acceleration

(ii) Extremely high inflation occurs when inflation rate is between 50% and 100% High inflation is a situation when the price level increases of 30% to 50% per year These kinds of inflation can stable or dangerously enter in an hyperinflation condition

(iii) Moderate inflation can be differently defined around the world, given the different inflation histories As an indication only, inflation can be considered at moderate rate when it ranges from 5% to 25-30%

(iv) Low inflation can be defined from 1-2% to 5% Around zero there is no inflation (price stability) and a country will face deflation when price level is below zero

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2.1.2 SOURCES OF INFLATION

Causes of inflation raise many macroeconomic debates This thesis only mentions theories which are related to the topic are Keynesian view and the quantity theory of money

Keynesian View

Implied from Keynesian view, economists believed that there are two main groups of inflation which are demand-pull or excess-demand inflation and cost-push or structuralist inflation Inflation occurred due to the fluctuations of aggregate demand (AD) and aggregate supply (AS) Therefore, in order to deeply understand two kinds of inflation, it

is necessary to remind the concepts of AD and AS

AD is the quantity of real GDP demanded or the total amount of final goods and services produced in a country that people (C), business (I), government (G) and foreigners (NX) plan to buy Another definition is AD is the sum of consumption expenditures (C), investment (1), government expenditure (G) and net exports (NX) That is

AD=C+I+G+NX

AD curve presents the relationship between the quantity of real GDP demanded and the price level The curve is downward sloping due to wealth effect and substitution effect Wealth effect informs that changes in price level with other things remain the same will lead to changes in real wealth Thus, people will try to restore their wealth by increasing saving and decreasing consumption Substitution effect said that people will substitute future consumption for present consumption as a result of higher interest rate In addition, changes in prices leads consumers to spend less on domestic items and more on imported items A change in price level can cause a movement along the AD curve whereas changes in consumption or investment as well as government expenditure or net exports may lead AD to shift leftward or rightward

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AS or aggregate production function is the aggregate quantity of goods and services supplied It presents how quantity of real GDP supplied (Y) depends on the quantity of labor (L ), the quantity of capital (K) and the state of technology (T) That is

AS = f(L, K, T)

At any given time, K and T are fixed, thus the higher the real wage rate is, the smaller the quantity of labor demanded is and the greater the quantity of labor supplied is

AS is divided into two time frames which are the short-run AS (SRAS) and the long-run

AS (LRAS) associated with the different state of labor market The macroeconomic short-run is a period which real GDP is smaller or greater than potential GDP The unemployment rate at that time has fallen below or risen above the natural employment rate SRAS curve demonstrates the relationship between the quantity of real GDP supplied and the price level in short-run when the money wage rate, other resources prices and potential GDP are constant The price level increases, holding the money wage rate and other resources prices constant, the quantity of real GDP increases and there is a movement along the SRAS curve

On the other hand, the macroeconomic long-run is a time frame that is sufficient long for all adjustment to be made; thus real GDP is equal to potential GDP and there is full employment As a result, LRAS curve shows the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP This curve is vertical as potential GDP is independent of the price level A change in the price level with an equal percentage change in the money wage and other resources prices, results in

a movement along the LRAS curve Changes in both the SRAS curve and the LRAS curve may cause by changes in potential GDP which depend on changes in the full-employment quantity of labor, changes in the quantity of capital or technological advance Besides, changes in money wage rate and other input prices only result in changes in the SRAS curve, not affect the LRAS curve

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The short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SRAS curve while the long-run macroeconomic equilibrium happens when real GDP equals potential GDP (Y*)

Figure 2.1: The Long-Run Macroeconomic Equilibrium

LRAS Price level

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Figure 2.2: Recessionary and Inflationary Gap

AD and the money wage rate behind short-run aggregate supply does not fall

Figure 2.3: Government Intervention When Recessionary Gap Occurs

Based on effects of changes in AD and AS on price level, Keynesian economists suggest two kinds of inflation which are demand-pull inflation and cost-push inflation argued below:

Demand-pull Inflation

This kind of inflation occurs when aggregate demand (AD) exceeds aggregate supply (AS) McTaggart, et al (2007) advised three main influences on aggregate demand which are the world economy, fiscal policy and monetary policy and expectations The world economy impacts AD through foreign exchange rate and foreign income An appreciation

in foreign exchange rate will lower the prices of domestic goods and services relating foreign goods and services; hence it increases exports, reduces import and rises AD In addition, growth in foreign income may lead the demand for home country's exports to

go up and increase AD Furthermore, changes in fiscal policy, for example a tax cut, will increase the households disposal income, encourage consumption and raise AD A loosening monetary policy which increases the quantity of money and reduces the interest rate may support investment, stimulate consumption and exports As a result, AD may go

up Finally, expectations about future income, future inflation and future profits can influence AD as increases in expected future income will increase present consumption and rise AD In case people predict higher inflation rate in the future, they will buy cheaper goods at present, resulting in higher consumption expenditure Consequently,

AD goes up Firms also increase investment at present time if they believe their future profits will increase; hence AD rises

Keynesian argued that an increase in aggregate demand when real GDP equals potential GDP will lead both GDP and price level initially increase At that time, AD curve shifts from ADl to AD2, output grows from Y* to Yl and price level rises from Pl to P2 On the other hand, demand growth may force firms to increase production and employ more labor to meet the high demand The unemployment rate is below the natural

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unemployment rate and leads a shortage of labor and wages to begin to go up Consequently, the SRAS curve will shift leftward from SRASl to SRAS2 The price level will rise from P2 to P3 then real GDP begins to decrease to return to the full-employment This is a one-time rise in the price level

Figure 2.4: An Increase In Aggregate Demand

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• Figure 2.5: Demand-pull Inflation Spiral

LRAS Price

"

Pl

" ' AD3

"'- AD2 ADl

Cost-push or Structuralist Inflation

Cost-push inflation is a result of increases in costs of production caused by rises in inputs' prices, money wage rate or supply shocks An increase in prices of inputs will lead production costs to rise Therefore, firms have to cut down production and reduce the quantity of labor employed The SRAS curve will shift leftward to SRAS2 resulting

in a fall in output and an increase in price level from P 1 to P2 A decrease in real GDP causes the unemployment rate to rise above the natural unemployment rate

Keynes ( 1940) suggested that the government should intervene the market by using fiscal policy or monetary policy to stimulus aggregate demand in order to restore the full employment In case the central bank rises the money supply, the aggregate demand will shift rightward to AD2 Consequently, the economy is returned to the full employment but price level rise further to P3

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Figure 2.6: An Increase in Short-run Aggregate Supply

to higher level and the full employment is restored A cost-push inflation spiral occurs

Figure 2.7: A Cost-push Inflation Spiral

LR.A.S Price

SRAS2 P5

Besides, structuralisms suggest the exchange rate is one of main sources of inflation Insufficient foreign reserve or depreciation in exchange rate will accelerate prices of imported goods, thus costs of production grows and consumer prices go up The fall in value of domestic currency can also lead to reduction in real wage Employees will require higher salary; hence it contributes to increase production costs and consumer prices The consecutive depreciation in exchange rate may result in continuous increases

in consumer prices As a result, inflation rises

Post Keynesians, in addition, pointed out the importance of global prices to domestic inflation A surge in prices of energy, raw materials or other inputs used in production will raise domestic production costs and significantly affect products' prices Higher prices of goods and services will rise consumer prices These effects are especially serious in small opened economies which depend much on importing inputs, energy and equipments In case the world prices of energy or inputs increase constantly, domestic consumer prices will go up continuously; thus inflation will rise

Monetarists View

On the other hand, monetarists believed that money growth is taken into account as the main determinant of inflation and they argued against the concept of cost-push inflation Their argument is that this kind of inflation can not occur without the interventions of government in increasing money supply when production costs rise If the quantity of money is constant, increases in cost of production of a product or service will reduce the money available for other goods and services Therefore, the price of some those goods may decrease and overcome growth in price of those goods whose prices have increased

According to Friedman (1956), inflation is always a monetary phenomenon He mentioned the quantity theory of money expressed by equation of exchange of Fisher

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( 1911) to explain for his definition of inflation The equation of exchange is presented following

M.Vr =PrT

Where

PT is the price level associated with transactions for the economy during the period

Tis an index of the real value of aggregate transactions

However, it is extremely difficult to estimate the above equation due to insufficient data

of transactions Therefore, an alternative equation which is more familiar is suggested

MV=P.Q

where

Vis the velocity of money in final expenditures

Q is an index of the real value of final expenditures or real output

The equation of exchange can be changed to the below version

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• With time-varying V and Q, the unrestricted equation is

percentage point rise in the inflation rate

However, according to Mishkin ( 1995), both monetarists and Keynesians believed that high inflation may only occur with repeatedly increases in aggregate demand caused by persistently increases in the quantity of money In order to promote sustainable economy growth with low inflation, both monetary policy and fiscal policy should be applied However, recent economists prefer monetary policy than fiscal policy due to the long time lag of the latter and the thread of government budget deficit

2.1.3 MONEY GROWTH

Money supply or money stock is defined as the total amount of money available in an economy at a particular point of time According the Federal Reserve Department (FED), the money stock consists of currency held by the public; transaction, savings, and time deposits held by the public at depository institutions; the assets of money market mutual funds; and certain other depository institution liabilities Money supply data are frequently recorded and updated by the government or central bank of the country

As there are different types of deposits at banks and other financial institutions, there are several different official measures of money The types of money stock are classified as

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i • r:·

"M"s and ranged from the narrowest MO to the broadest M3 Definition of "M"s depends

on the central bank of each country or region According to Bernanke (2006), in the United States, FED defined money aggregate as Ml, M2 and M3 Ml is currency and demand deposits at commercial banks M2 equals M 1 plus commercial bank savings and small time deposits, deposits at mutual savings banks, savings and loans, and credit unions M3 is equal to M2 plus large time deposits

On the other hand, European Central Bank defined Ml is currency, such as banknotes and coins, as well as balances which can be immediately converted into currency or used for cashless payments, i.e overnight deposits M2 which is the intermediate money equals Ml plus deposits with a maturity of up to two years and deposits redeemable at a period of notice of up to three months M3 comprises M2, money market fund shares/units, repurchase agreements and debt securities up to two years

McTarggart (2007) suggested that there are three measures of money stock in Australia

Ml consists of currency held by households and firms plus current deposits at banks and excludes currency held by banks and governments M3 equals Ml plus all other deposits

at banks, including term deposits and certificates of deposits Broad money is defined as M3 plus deposits at financial institutions other than banks

The role of money stock in explaining inflation and economic growth is demonstrated in the quantity theory of money The theory emphasizes the following relationship of the

nominal value of expenditures PQ and the price level P to the quantity of money M:

Friedman ( 1987) suggested that empirical studies have found relations consistent with above models and with the role of money to prices A change in the money supply in the

past will be relatively more associated with a change in real output Q than the price level

P in (2.1) but with much variation in the precision, timing, and size of the relation in the short-run For the long-run, there has been stronger support for (2.1) and (2.2) and no

systematic association of Q and M

With important roles to the economy, growth in money supply is one of the most concerned of governments Growth in money supply can be affected by central banks through monetary policy The term monetary policy refers to the actions undertaken by a central bank to influence the availability and cost of money and credit as a means of helping to promote national economic goals There are many types of monetary policy such as inflation targeting, monetary aggregate, fixed exchange rate and mixed policy depending on the economic objectives of each nation Central banks will change money supply; thus they influence the economy through several channels named monetary transmission mechanisms Central banks usually approach five main channels which are reserve requirements, discount window lending, open market operation, interest rate, and exchange rate in order to intervene economies

Firstly, reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities Banks are frequently required to keep

a small proportion of their assets as cash available for immediate demand of withdrawal The rest assets will be invested or given loans Therefore, high reserve requirement rate will reduce available funds, hence loanable capability of banks goes down and vice versa

By changing reserve requirement, the central banks will directly affect the availability of loanable funds of banks and cause changes in money supply Reserve requirement is a powerful tool when a modest change in its rate will comprehensively equally influence banking system However, its strengthen is also its weakness as this tool can not be

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applied in case central banks only want to change money stock moderately In addition, frequent increases in reserve requirement rates will reduce banks' profits as well as lead the economy to imbalance and affect banks' liquidity Consequently, central banks usually do not prefer this channel

Secondly, discount window lending is where the commercial banks, and other depository institutions are able to borrow money from the central bank, usually on a short-term basis,

to meet temporary shortages of liquidity The interest rate charged on such loans by a central bank is called the discount rate, base rate, or repo rate At that time, central banks become the last lenders of the economy through intermediate institutions such as banks and depository institutions It provides money or loanable funds to the economy, thereby affects the money supply However, with this instrument, central banks may depend on the demand of funds of depository institutions

Thirdly, open market operations is an important tool to impact the quantity of money Central banks will buy or sell short-term valuable documents, for example treasury bills,

to banks and financial institutions Selling valuable documents at attractive rates will encourage banks to buy them, thus reduces banks' available funds for giving loans Consequently, money stock provided to the economy will go down This tool can offset disadvantages of the previous tool as central banks may actively use it without depending

on banks It also can be applied flexibly, preciously at any level following central banks' management

Fourthly, interest rate is a powerful instrument for central banks to intervene markets Lower interest rate will encourage consumption and investment as well as lending As a result, the quantity of money increases There are two main methods controlling interest rate which are indirect and direct methods Central banks indirectly control interest rate

by announcing base rate to instruct markets or adjusting discount rate or refinancing rate

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- On the other hand, central banks can directly manage interest rate by imposing interest

rates in different time terms, applying lending ceiling rate or deposit flooring date; announcing base rate and adjustment range

Finally, central banks may use exchange rate to impact money stock Considerable appreciation in domestic currency will lead domestic goods and services to be more expensive, thus it reduces exports and increase imports In order to decrease the value of domestic currency, the central bank can sell foreign currency to the economy to increase the supply of foreign currency However, by selling foreign currency, the central bank does increase the quantity of domestic currency to the economy at the same time

2.2 EMPIRICAL LITERATURE

There are a majority of papers examining the impact of money growth on inflation An illustration of this is the study of Moroney (2002) The research tried to estimate the long-run model of the quantity theory of money as well as the partial contribution of money growth and real GDP to inflation then make out-of-sample forecast Based on assumption that real GDP growth depends on exogenous factors including growth in human capital, physical capital and technology advance, the quantity theory of money is tested following

a regression model:

Y; =Po+ P,Xi + P2Z, +&,

Where Yi is the country's inflation rate which is represented by GDP deflator, Xi stands for its money growth rate which is defined by M2 and Zi is its real GDP growth rate

The author used a sample data of 81 countries including 27 African countries, 15 Latin American countries, 16 Organization for Economic Co-operation and Development (OECD) countries, China, Indonesia, Pakistan and India from 1980 to 1993 Firstly, the research estimates the model with full sample by using Ordinary Least Square (OLS)

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method Then hypotheses tests are applied to test if the model's coefficients follow the restriction version where Po= 0, p, = 1 and P2 = -1 Estimation results demonstrate that the null hypotheses can not be rejected at 1% Furthermore, in order to examine the different contribution of this theory in inflation explanation among different kinds of countries, the author divided countries into small groups and compared them Low-income nations are compared with upper-middle and upper-income countries, African nations are versus Latin American countries, high-income countries and finally high-money-growth, high-inflation countries are compared with low-money-growth, low-inflation countries

The empirical finding of this study confirms again the important contribution of the quantity theory of money in explaining inflation High money growth statistically significantly impacts inflation and this effect is one to one Growth in money supply also plays more important role to inflation compare with economic growth However, this theory is less effective in inflation's analysis in low-money-growth, low-inflation countries apart from its poorly estimation results Therefore, further research to test the role of the theory in low-money countries is suggested

With the same idea, De Grauwe and Poland (2005) used cross sectional data of 160 countries from 1969 to 1999 in order to examine the application of the quantity of theory and focused on how different it is applied in high-inflation and low-inflation countries The research is based on the proposition that the relationship between money growth and inflation is a one-to-one relationship The differences between this study and the first study are CPI is represented inflation rate instead of GPD deflator and the study uses both M1 and M2 in order to compare their effects on inflation instead of only M2 The regression equation is following

P; =Po+ P1m; + P2Y; + Jl,

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y Where Pi is the growth rate of inflation, mi is money growth rate and Yi is growth of

output Estimating the whole sample by applying OLS shows an important finding which

is the positive long-run connection between money growth and inflation but not a one effect like the previous study

one-to-After that, data is divided into two groups of low-money-growth and high-money-growth nations to find different application of the theory as there is a potential bias when grouping observations in level of inflation The finding is the effects of growth in money supply on inflation in high-inflation, high-money-growth countries is stronger than its effects in low-inflation, low-money-growth countries Finally, generalized least square (GLS) estimation results show a firm link between money growth and fixed effects or country-specific effects After that, six dummy variables represented level of inflation are added to examine the different effects on inflation of money supply growth The authors discovered that in high-inflation regimes, price reflects more quickly to monetary shocks than it is in low-inflation regimes

In addition, Thornton (2008) gives a similar conclusion that there is a conditional influence of money supply on inflation The study takes observations in 36 African countries from 1960 to 2007 to test the medium-and long-run link between increase in money stock and inflation; focus on re-examine the findings of De Grauwe and Poland (2005) The author did adjust methodology of the previous research by re-sizing sample

in a "more homogenous country group than the De Grauwe and Poland sample" Both cross-section analysis and panel data analysis are used Evidences from cross-section analysis present that there is a strong positive impact of money growth on inflation in long-run and this relationship does not depend on the level of money growth rate provided that low money growth rate is defined as below 15% Furthermore, this study also suggests the same results as the previous study in 2005 when finding out the effect of money on inflation is not proportional, the coefficients of money supply is frequently

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greater than 1 in high-money growth countries but lower than 1 in low-money growth countries In addition, an increase in money stock also does not permanently influence output growth

In addition, this research overcomes the criticism of De Grauwe and Poland research by taking into account the lags between money growth and inflation in panel data analysis With a money lag of ten years then "shortened them on the basis of the Schwartz Bayesian Criterion", the estimation result presents that lagged growth in money supply considerably impacts inflation with statistically significant lags up to six to seven years Moreover, six dummy variables represented levels of inflation are added to examine different impacts of money growth on inflation The finding is that there is a modest connection between money growth and inflation when they are below 10% whereas this relation is strong when increase in money and growth in price level are much above that rate This result is independent of inclusion of high-inflation country

In the same year, Kaufmann and Kugler (2008) develop a model including six variables: the harmonized consumer price index, M3 growth represents money growth, output gap, GDP growth, long-term nominal interest rate denoted by ten-year government bond rate and the short-term interest rate denoted by three-month rate in order to examine the dynamic dependence of inflation on money growth in the short-run and long-run Vector error correction model (VECM) is applied to estimate quarterly data from 1977 to 2006

in Euro area Variance decomposition and impulse responses tests are approached to express the robustness of this relation Estimation results point out there is a robust and stable co-integration between money growth and inflation In long-run, shock in M3 growth accounts for up to 30% of inflation forecast error variance

A recent study, Basco, et al (2009) takes into account the money-inflation relation focusing on specific country Argentina from 1977 to 2006 The authors intended to

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• examine the variety effects of money growth on inflation Quarterly data is divided into

two regimes which are high-inflation period between 1977 and 1988 of which monetary/exchange rate schemes were launched and a period of low inflation from 1993

to 2006 when a currency board scheme and a monetary targeting under a managed floating scheme were adopted Inflation is represented by logarithm of CPI and money growth is measured by logarithm of M1 seasonal adjusted The correlation between two variables is examined in low and high frequency data which are annual changes and monthly changes respectively It shows a long-term significant relation between money and prices In addition, co-integration analysis suggests similar results as the above studies that the effects of money growth on inflation depends on level of inflation Furthermore, this link is firm and proportional under high-inflation period but weakens in low-inflation regime

Moreover, in order to examine more preciously the short-run connection between money growth and inflation, the authors adds other relevant factors affecting inflation which are the nominal interest rate on time deposit represented inflation expectations, GDP growth and the change in the multilateral nominal exchange rate with the main trade partners Vector auto-regression (V AR) model is approached for the whole samples, observations

in high-inflation regime and observations in low-inflation regime in order to test impulse response functions and variance decomposition The authors discovered a more important contribution of growth in money stock in explaining inflation dynamics when changes of monetary policy are occurred Consequently, money still has a significant effect on inflation in Argentina in both high-and low-inflation regime

Gingting and Bird (2009) also discovered that money growth is the most significant factor affecting inflation in Cambodia in short-run and plays important roles in explaining inflation in long-run by testing monthly data from December-2003 to July-2008 Based

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- on empirical studies about inflation in a small, open economy, the research applied the

below model to examine sources of Cambodia's inflation in long-run:

Where 1r;AM is yearly percentage change of inflation in Cambodia; tr{Nr is yearly

percentage change of inflation in trading partners, ER{Nr is weighted yearly percentage

change of trading partners' exchange rate, M11 is yearly growth of narrow money and Dt

is dummy variable to express the excess output gap in 2007

The important findings are in the long-term, narrow money which is a closer determinant

of inflation than M2, according to the authors, plays an important role in explaining core inflation whereas it plays the most significant role in explaining core inflation in short-term

In case study of Vietnam, there are some studies confirming the positive impacts of money growth on inflation Firstly, Baker, et al (2006) argued that money aggregate, output gap and exchange rate may be the main determinants of Vietnam's inflation Therefore, the study develops a model contains CPI represented inflation, independent variables are broad money M2, nominal effective exchange rate and output gap VECM

is applied to analyze quarterly data from 200 !-quarter 1 to 2006-quarter 2 The findings indicate that monetary factors become significant determinant of inflation in Vietnam with a lag of about 12 months

Furthermore, in order to explain the relative high inflation in Vietnam compared with neighbor countries, a cross-country dynamic panel model is applied to test the same period of time Compared countries include China, Indonesia, Korea, Malaysia, Philippines, Singapore, and Thailand A differenced generalized method-of-moments (GMM) estimator allowing past actual values of inflation to affect its current level is

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presented The estimation results present the relative high inflation in Vietnam can be explained by higher degree of persistence in inflation and stronger influence of money supply

In the same year, a research of Goujon (2006) argued that after hyperinflation period from 1986 to 1988 due to loosen monetary policy and significant fall in value of national currency, the economy was transformed from centrally planned economy to market economy This evolution including dollarization and money supply management did help the country to successfully control inflation in the 1990s In order to enhance the author's argument, the paper intends to build an econometric model explaining inflation in the reform period

Starting from inflation formula, inflation is measured by weighted average of price indices of tradable and non-tradable goods following below equation

~~ =8/1p; +(l-8)/1p/NT

Where p is log of price index, !1 is the first difference operator, and e is the constant weight of the prices of tradable goods in the CPI with 0 < e < 1 p Tis log of the prices of tradable goods depending on the nominal exchange rate, the world prices of tradable goods in foreign currency and the evolution of other factors such as transportation and transactions costs or trade policy pNT is log of the prices of non-tradable goods calculated

by excess money and the nominal exchange rate

VECM is applied to test the equation based on monthly data from January 1991 to June

1999 CPI is used as price index, M2 represents nominal money and real income is measured by monthly industrial output The principal finding is that inflation in Vietnam

in the 1990s is driven by exchange rate and excess of broad money Consequently, the

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study believes that a co-operation between exchange rate management and tightening monetary policy based on broad money will succeed in controlling inflation in Vietnam

In contrast, Fie (2003) suggested that growth in money supply does not significantly affect inflation when testing the impacts of money, labor and external factors on the German inflation The author based on the research of Kim (200 1) to examine three main sources of inflation which are monetary inflation, wage inflation and imported inflation General-to-specific methodology or eclectic approach is applied for quarterly data from 1980-quarter 1 to 2001-quarter 4 Firstly, cointegrating relationships are estimated separately as single equations After that, the error correction terms are obtained and inserted into the inflation equation which includes deterministic factors, money stock, output gap, unit labor costs and imported prices with 8 lags The important findings are excess money does not have a significant effect on inflation and German inflation depends on production factors, level of capacity utilization, imported prices and monetary policy actions

In case of Vietnam, although Thanh (2008) points out a positive effects of money supply

on Vietnam's inflation, this contribution is modest The autoregressive distributed lag (ARDL) method is applied for yearly data from 1990 to 2007 to estimate an equation including CPI denotes inflation, independent variables are nominal exchange rate of VND against USD, M2 represents broad money supply, GDP measures output value and commodity price index of the world including all primary goods with base year is 2005 denotes world price In addition, when comparing with other neighbor countries, the author comments that money growth seem not to be a worry due to its insignificant impact in inflation

In addition, the empirical results of Hung and D.Pfau (2008) suggest an unobvious influence of money supply on inflation when they try to examine the overall impact of

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money to the economy A basic model including CPI, real industrial output represents output value and M2 denotes monetary policy shocks as growth rate of M2 with a vector

of external factors including oil price, rice price and the United State federal funds rate is taken into account as an operating target for the State Bank of Vietnam in formulating and implementing monetary policy is suggested Data is quarterly collected between 1996-quarter 2 to 2005-quarter 4 from International Monetary Funds (IMF) International Financial Statistics; Vietnam General Statistics Office Causality tests inform money does not Granger cause inflation, its contribution to explain inflation is extremely modest Furthermore, impulse response functions present an increase in money supply will decrease inflation in the first two quarters before rise inflation from quarter 3 to quarter 8 due to "price stickiness"

2.3 AN OVERVIEW OF INFLATION AND MONEY GROWTH IN VIETNAM FROM 2000 TO 2010

2.3.1 INFLATION

After Asian financial crisis in 1997, Vietnam faced deflation between 2000 and 2001 The country's inflation started increasing since 2004 due to demand stimulus polices, world economy growth and a surge in world prices of goods and services According to GSO, the CPI in December 2007 rose up to 12.67% compared with its same period in the previous year The CPI continued going up in the beginning of 2008 then achieved a peak

at about 30% in July 2008 Thanks for tightening monetary policy of the State Bank of Vietnam and governmental solutions restricting inflation since September 2008, the inflation rate fell significantly CPI in the last 3 months of2008 were negative However, for the whole year, inflation rate was still extremely high at 19.89% compared with December 2007 and the average CPI was about 22.97% which was the highest rate in the last 17 years, informed by GSO In contrast, inflation rate in 2009 dropped dramatically

as the American financial crisis in 2009 negatively influenced world prices and foreign

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demand CPI in December 2009 only rose 6.52% compared with its same period in the previous year The average inflation rate in 2009 was 6.88%

In 2010, with loosening monetary policy and demand stimulus policies, the economy started recovering GDP increased gradually from 5.84% in quarter 1 to 6.44%, 7.18% and 7.34% in quarter 2, quarter 3 and quarter 4 respectively However, CPI began going

up significantly, causing adversely impacts in households' living standard CPI in December 2010 increased up to 1.28% compared with the previous month and 11.75% compared with December 2009 The average inflation in this year was 9.9% In a governmental press conference at the end of December 2010, according to Quan (20 11 ), the GSO's bureau chief believed that high inflation in 2010 was resulted from money growth A GSO's report estimated that monetary factors contributed up to 4.65% of 11.7 5% of inflation rate in 2010 On the other hand, the governor of the State Bank of Vietnam in this press conference argued that high inflation in the last year was not caused

by monetary policy management but from objective factors such as instable economy, high input prices and some subjective internal factors of Vietnam's economy, reported by Anh (20 11 ) Therefore, the effects of money on inflation still raises many debates in Vietnam

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Figure 2.8: CPI in December and Average CPI from 2001 to 2010

in money stock in this period The growth rate of money supply significantly increased from below 20% in 2002 to around 30% in 2004 before reaching a peak at 46.5% in 2007

In contrast, in 2008 the money growth rate sharply went down to 25% due to strongly tightening monetary policy to control high inflation rate in the end of 2007 The next year was a challenged year for world economy as well as Vietnam economy when financial crisis starting from the United States occurred In order to maintain the economic growth rate, the Vietnamese government loosened the monetary policy, especially through interest-support policy for production Thus, the broad money

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increased slightly to approximately 2% in 2009 Referring to figure 2.5, CPI also went up dramatically from below 5% in 2002 to nearly 13% in 2007 then got a peak at over 20%

in the next year Consequently, money supply may positively affect inflation after a period oftime since the former increases between 2002 to 2010

Figure 2.9: Broad Money Growth From 2002 To 2010

0 00" 0 + - - - - - - - - - , - - - , - - - - , - - - , - - - , - - - - , - - - ,

:oo2 :oo3 200~ :oo5 2oo6 2oo- 2oos :oo9 :oto

Source: The State Bank of Vietnam

2.4 CHAPTER REMARK

To summarize, the positive effects money growth and inflation are admitted by Keynesian view and monetarism The short-run impact of money on inflation is explained by AD-AS model while the long-run contribution of money on inflation is presented by both the quantity theory of money and Keynesian view Besides, almost empirical studies in foreign countries suggest a positively significant effects of money growth on inflation although there are arguments regarding the proportion of this relationship In addition, money supply is suggested to stronger influences inflation in

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high-inflation countries than it is in low-inflation countries in long-run In contrast, the contribution of money growth in explaining inflation is unobvious in case studies of Vietnam Some papers confirm its positive effects whereas others pointed out unobvious impact of money growth on inflation in the country

Regarding methodology, Engle - Granger and Johansen cointegration tests with error correction model (ECM) are preferred to examine the long-term effects of money on inflation In contrast, Granger causality, variance decomposition and impulse response functions in V AR model or VECM are employed to examine the short-run contribution

of money growth in explaining inflation

Regarding Vietnam's inflation, CPI started increased dramatically since 2004 thanks for demand stimulus policies, growth in world economy as well as prices of goods and services Vietnam inflation rate reach a peak at 30% in July 2008 before tum around In contrast, the inflation rate in 2009 sharply went down due to negative effects from the American financial crisis In this year, Vietnamese government loosen monetary policies and applied demand stimulus package to support economic growth However, these polices encouraged a significant increase in inflation As a result, CPI at the end of 20 10 went up to 11.75% compared with December 2009

With the similar trends, money supply in Vietnam continuously rose since 2002 before reaching a peak at about 45% in 2007 as easy monetary policy was applied to promote economic growth After that, the high inflation rate in the end of 2007 raised many concerns for the government, thus strongly tightening monetary policy was used to control inflation As a result, the growth rate dramatically fell in 2008 to 25% then fluctuated about this percentage in the next two years The trend of broad money is similar with trend of inflation in Vietnam with time lag Therefore, lagged money growth possibly positively impacts inflation at present

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CHAPTER 3: RESEARCH METHODOLOGY, MODEL

SPECIFICATION AND DATA SOURCES

This chapter will describe the analytical framework in order to give an overview about methodology used in this thesis After that, this part will introduce a model of which inflation is dependent variable to examine the short-run effects of money growth on inflation The sources of data is also mentioned in this part Finally, main econometric techniques which are employed in this thesis are briefly explained

Regarding literature review and empirical studies, an analytical framework is made above The thesis will focus on the effects of money growth on inflation in long-run and short-run Firstly, Enge-Granger cointegration test is employed to test the long-run influence of money on inflation Then the error correction model (ECM) is used to examine the effects of money growth on inflation in short-run as well as perform the speed of adjustment of inflation driven by money growth in long-run After that, Johansen cointegration test is applied to re-confirm the contribution of money on inflation in long-run when putting money growth to the model of determinants of inflation with four control variables which are output, credit, exchange rate and interest rate The test also inform the number of cointegration equations in the model in order to apply vector auto correction model (VECM) Finally, Granger causality, variance decomposition and impulse responses functions are employed to explore the short-run effects of money growth on inflation as well as the importance of money supply in explaining inflation in Vietnam

3.2 MODEL SPECIFICATION

In order to examine the short-run effects of money growth on inflation, the research develops a model of which several factors are added beside money growth to prevent missing variables Table 3.1 presents description, expected signs of these variables

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