UNIVERSITY PUTRA MALAYSIA

Faculty of Economics and management

Title:

The Impact of Budget Deficit on Money

Demand in Iran

FATEMEH RAZMI

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TABLE OF CONTENTS

Pages
1. INTRODUCTION 3
2. THEORICAL BACKGROUND 4
3. DATA AND EMPERICAL BACKGROUNDS 5
4. UNIT ROOT AND COINTEGRATION TESTS 7
5. GRANGER CAUSALITY TEST 11
6. THE DYNAMIC INTERACTIONS 13
7. CONCLUTION 18

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 INTRODUCTION

Monetary sector plays an important role in determining the level of key macro-economic variables

like income, employment and prices. The importance of monetary economics has inspired many

economists to undertake research in this field.

Money demand affects on macro variables so its regarded as one of the most important variables

in every economy. Policy makers should know real money demand for analyzing of

macroeconomic problems and making appropriate decisions to solve them.

The impact of some variables such as gnp and interest rate on money demand is significant but

there are some different views on the impact of budget deficit on money demand. On one hand in

neoclassical and Keynesian models, the budget deficit has a positive impact on money demand, on

the other hand in Ricardian models budget deficit doesn’t affect on money demand. This paper

will show Iran’s money demand correspond to which of the above mentioned theories by evidence.

Since in recent years iran suffers from budget deficit, positive impact of budget deficit on money

demand will bring a lot of negative effects to economy. policy makers should attend more than

before on budget deficit.

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 THEORICAL BACKGROUND

There are three perspectives on the relationship between money demand and government budget

deficit. Keynesian , Ricardian and Neo classical perspectives.

In Keynesian approach, decreasing the tax or increasing government expenditure lead to rise of

money demand. Financing the budget deficit through issuing bonds cause the consumption

increase (because of the effect of wealth on consumption (harris,1985)). The high consumption

expenditure will stimulate the national income through multiplier process. Since money demand

is a function of national income, the money demand will increase (Gully, 1994).

Barro (1974) extended the Ricardian approach about budget deficit. He explained that budget

deficit has no impact on money demand. Under the assumption of fix government expenditure and

no limitation for borrowing, the cuts on taxes have no impact on national savings, the presence of

tax cuts means high future taxes. Although financing government budget deficit by issuing the

bonds increases the wealth of the households, it rises government liabilities to households.

Government will increase the taxes in order to redeem the bonds. If the assets and liabilities are

equivalent, households will not suppose themselves richer than before, so budget deficit don’t

effect on consumption. National savings and interest rate don’t change. As a result, aggregate

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demand would not be affected and the IS-LM equilibrium will not shift. Therefore, the budget

deficit has no impact on consumption, saving, interest rate, investment and money demand.

Neoclassic analysis the effect of budget deficit on consumption in short run and long run. In short

run they have similar views with Keynesian’s but in long run Classical model is different from

Keynesian model. They assume in long run the output is fully employed so the output will be

independent with budget deficit. The households suppose their wealth increase as a reduction in

other private expenditure. Hence, the budget deficit has no impact on money demand in long run.

DATA AND EMPERICAL BACKGROUNDS

There are two variables for measuring money demand, M1 and M2, this study uses RM2 as a

measurement of real money demand that is realized by using cpi.

Two effective variables in estimating money demand are wealth and intrest rate, but measuring the

value of national wealth in developing countries is very difficult. Real gross national product is a

good substitute for wealth. This study implements LRGNP (log of real gnp) as a substitution of

wealth. In the case of interest rate, because of no efficiency of monetary markets and financial

markets in developing countries, interest rate doesn’t show the real relationship between money

demand and interest rate. Inflation can perform the role of interest rate in estimating money

demand. this study use cpi instead of inflation.

All the data are from 1972-2006 and collected from Central Bank of Iran statistics. *

*http://www.cbi.ir/

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The purpose of this study is to find weather the budget deficit in Iran has impact on money demand

or not, RBD is real budget deficit that is implemented as opportunity cost variable.

Waded Saad (2009) in his study found positive relationship between M1 and government

expenditure in Lebanon but the study of Hamad A. AL- Towaijri and Khalid H. A. Al-Qudair

(2006) showed negative relationship between money demand and government expenditure in

Saudi Arabia.

Although the important variables LM2 , LRGNP , LCPI and RDB may be sufficient for finding

the relationship between money demand and inflation rate , some other important variables can be

effective on estimating money demand . Arango and Nadir (1981), Oskoee and Poorheidarian

(1990) found a significant effect of exchange rate on money demand. According to the previous

studies exchange rate is a fine variable that can determine the opportunity costs. In this study

LREXC (log real exchange rate) is used as opportunity cost index.

The vector autoregressive is adopted to find the effects of budget deficit on money demand. In the

first step unit root must be tested. This study employs Augmented Dicky – Fuller and Philips-

Peron test. If the order of integrated of all variables are 1, the study can proceed with cointegration

test introduced by Johansen and Juselius (1990). this approach starts with the following

unrestricted vector error correction model:

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  t=1,2, T


Where Xt is column of variables

𝐿𝑅𝑀
𝐿𝑅𝐺𝑁𝑃
𝑋𝑡 = 𝐿𝑅𝐵𝐷
𝐿𝐶𝑃𝐼
𝐿𝑅𝐸𝑋𝐶

is an intercept, is a Gaussian error term, and T is the total number of observations.

This model contains information on both the short run and long run adjustments to changes in Xt

via the estimates of and , respectively. Testing for cointegration amounts for a consideration of

the rank of . If the rank ( ) = r, then three cases are to be considered:

• If r = 0, the variables are not cointegrated and there is no relationship among them that is

stationary. In this case, the appropriate model is a VAR in first differences involving no longrun

elements.

• If r = n, then all the variables in the model are stationary and there is no problem of spurious

regression. The appropriate modeling strategy is to estimate the VAR model in levels.

• If 1< r < n, then cointegration is indicated (with r cointegrating vectors present).

After testing for existing cointegration, the Granger causality through VECM is implemented to

find the causality between variables in short run and long run.

At the end impulse response and variance decomposition are implemented. The impulse response

functions trace the effect of a one-standard deviation shock to the budget deficit variable on money

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demand , while the variance decompositions show the relative importance of the budget deficit in

explaining variations in money demand .

UNIT ROOT AND COINTEGRATION TESTS

The first step in Johansen cointegration test is the unit root test of all variables. table 1 and 2 show

the result of unit root test with Phillips Perron and Augmented Dicky Fuller test. The null

hypothesis is the existence of unit root test. Neither the variables in level reject the null hypothesis

in 5% level but after differencing all reject the null hypothesis. All variable are stationary in first

difference so all are I(1).

Table 1 : ADF and PP unit root tests (level)

intercept Trend and intercept

variable lag Adf pp lag Adf pp
Lrm 0 -1.34 -1.53 0 -2.02 -2.54
Lrgnp 0 -0.1 -1.09 1 -2.26 -2.51

Rbd 0 -1.13 -1.13 0 -0.82 -0.64

lrexc 0 -0.2 -0.73 0 0.52 -0.76

Lcpi 1 -0.26 0.05 1 -1.89 -2.39

Critical value in 5% for intercept: -2.95

Critical value in 5% for intercept : -3.56

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 Table 2 : ADF and PP unit root tests (difference)

intercept Trend and intercept

variable lag Adf pp lag Adf pp
Lrm 0 -3.37 -3.33 0 -3.19 -3.11
Lrgnp
0 -3.74 -3.78 0 -3.65 -6.19
Rbd
0 -5.54 -5.50 0 -5.65 -5.61
Lrexc 0 -3.91 -3.94 0 -4.28 -4.25
Lcpi
1 -3.89 -3.04 0 -3.16 -2.96
Critical value in 5% for intercept : -2.95

Critical value in 5% for intercept : -3.56

The next stage is to conduct cointegration test but before using Johansen and Juselius this point

should be mentioned that dummy variable is employed for the year after Revolution because of

structural differences after and before revolution so

Dummy=0 before revolution

Dummy=1 after revolution

According to Hall (1991) in JJ test the results may not show the reality, if incorrect lag length is

implemented. For choosing the best lag for cointegration test and vecm the study uses the lag

length that there is no serial correlation in error terms. All error terms were serially uncorrelated

in lag two. So the lag length two is chosen for JJ test and vector error correction model. Appropriate

lag length is needed for finding the number of cointegrated equation in long run. Table 3 shows

the result of cointegration test that is relied onto two statistics, trace statistics and maximal eigen

statistics. r indicates the number of cointegrated equation in nul hypothesis. The critical value of

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max Eigen and trace are in 5% level. Both statistic reject the null of no cointegrated equation. The

null hypothesis of at most three cointegrated equation cannot be rejected with trace statistic (trace

statistic < trace critical value so the null hypothesis of r ≤3 cannot be rejected). With maximal

eingen value the hypothesis of at most 3 long run equation is acceptable too, so the two statistic

support of long run relationship between all variables.

Table 3: JOHANSEN COINTEGRATION TEST

Trace Maximal Eigen

Null hypothesis Trace Maximal Eigen
Critical value critical value

r=0 124.8923 53.80720 69.81889 33.87687

r ≤1 71.08505 33.29137 47.85613 27.58434

r ≤2 37.79368 24.27975 29.79707 21.13162

r ≤3 13.51394 10.94343 15.49471 14.26460

r ≤4 2.570502 2.570502 3.841466 3.841466

Table 4 presents long run equation normalized on LRM2 (obtained from JJ procedure). The signs

of estimated long run parameter are in harmonize with theory. There is positive relationship

between money demand and GNP, the coefficient of LRGNP present the long run income elasticity

(GNP is a substitution for income in money demand function) of money demand. If GNP changes

1%, money demand will change 1.26%. The positive sign of the coefficient of real budget deficit

supports the Keynesian-Neoclassical model so financing the budget deficit through issuing bond

leads to increase the demand for money. The negative effect of exchange rate on money demand

shows exchange rate is an appropriate substitution for money demand. When exchange rate

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increase people increase their demand for foreighn currency and decrease their demand for

domestic currency. The negative sign of coefficient of LCPI indicate

Inflation cause money demand decrease, in these situations people shift their demand from money

to money substitutions.

Table 4: Long run equation normalized on LRM

Normalized cointegrating coefficients (standard error in parentheses)

LRM RBD LRGNP LREXC LCPI
-1.000000 0.001274 1.266107 - 0.370058 -0.111217
[-4.22753] [-5.38458] [ 3.08387] [ 2.96504]

the number in [ ] are t statistics

GRANGER CAUSALITY TEST

Cointegration test shows the long run relationship between variables but don’t indicate the casual

relationship between variables so the VEC granger causality test is employed to find the direction

of causality in short run. According to Engle and Granger (1987), when there is at least one

cointegrating vector of the cointegrated series, the corresponding error-correction representation

will exist. Table 6 cite the long run and short run interactions between variables. The ECT (error

correction term) implies the long run causal relationship between variables. It also represents the

speed of adjustment to long run equilibrium that affects short run movements in real money

demand.

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The -statistics and probabilities are shown in the table 6 . The hypothesis in this test is that the

lagged endogenous variables do not Granger cause the dependent variable. It can be found from

the first row that the null hypothesis that in short run LRGNP is not granger cause LRM cannot be

rejected, while LREXC and LRBD are granger cause LRM in 5% and 10% levels. The LRM isn’t

granger cause LRBD and LREXC so it can be said the causality between LRM and LRBD, LRM

and LREXC is not bilateral causality. The lagged ECT are statistically significant at 5% level and

shows the long run casual relationship between LRM and LRGNP, LRBD, LCPI, LREXC.

Also the lagged ECT represents the speed of adjustment to long run equilibrium that affects short

run movement in real money demand. The negative sign implies that all variables work together

to reach the equilibrium in the long run. The absolute coefficient of lagged ECT shows that 0.33

of disequilibrium in LRM2 is adjusted per year thus it takes about 3 years for LRM2 to return to

its long run equilibrium.

Since the coefficient of ECT is significant the following equation can be written for discussing

more about the relationship between RBD and LRM.

LRM=f ( Z)-0.33ut-1

ut-1=LRMt-1-( 1.26LRGNPt-1+ 0.0012LRBDt-1 -0.37LREXCt-1-0.11LCPIt-1)

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The equation shows that LRM will increase when ut-1 < 0. The increase in LRBD will lead that ut-

1 to be less than zero and therefore LRM increase and vice versa

Table 6 : Granger causality tests

-statistics of lagged first-differenced terms

dependent variable↓ ECT (t ratio)

LRM LRGNP LRBD LREXC LCPI

-0.339413
0.508 5.555 6.484 0.070
LRM - (0.13484)
(0.7755) (0.0622) (0.0391) (0.9655)
[-2.51712]

0.062771
1.352 0.471 1.890 1.918
LRGNP - (0.10207)
(0.5086) (0.7901) (0.3885) (0.3832)
[ 0.61498]

-17.53715
2.233 0.084 1.896 0.093
LRBD - (144.626)
(0.3274) (0.9587) (0.3874) (0.9545)
[-0.12126]

-0.512975
1.523 6.850 9.682 1.289
LREXC - (0.18873)
(0.4668) (0.0325) (0.0079) (0.5248)
[-2.71797]

0.232305
4.199 0.408 0.442 2.680
LCPI - (0.11426)
(0.1225) (0.8151) (0.8015) (0.2617)
[ 2.03317]

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 THE DYNAMIC INTERACTIONS

For finding dynamic interactions between variables, impulse response and variance decomposition

is employed. Impulse responses measure the time profile of the effect of a shock, or impulse, on

the (expected) future values of a variable. As in Phylaktis (1999), impulse response analysis based

on the vector autoregressive (VAR) model in this study. As you know impulse response and

variance decomposition are sensitive to the ordering of variables. In this study several orderings

are tried but the results were similar. One ordering is used in this study LRGNP, LCPI, LEXC,

RBD, LRM.

Figure 1 shows the effects of a one-standard deviation shock to the budget deficit variable on other

variables. RBD to LRM has positive impact but it is significant just for two years (3 and 4).

LREXC has negative impact on LRM and it can be said the response of LRM to LREXC is

significant in short run. Other variables except LRM have no significant effect on LRM.

Figure 2 illustrates the impacts of one standard deviation shock to the LRM on other variables. All

variables show significant response to LRM in short run but response of RBD and LRGNP to LRM

is positive and significant until the year 5th and 6th. LREXC and LCPI response negative and

significant until the year 3.So the LRM have the most impact on RBD among other variables.

Table 7 implies the variance decomposition of LRM and RBD. the variation of LRM is totally

explained by itself in first period. The share of LRM to explain the variation remain more than

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others until the last period. Among other variables RBD plays the most important role in explaining

the money demand variation. It increases gradually from 0.42 to 13.43.

From the table 8 in first and second period the most variation is explained by RBD but as time

goes the share of LRM increases. On the last period the share of LRM on explaining the variation

of RBD is three times more than RBD.

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 Figure 1: Reponses of LRM

Response to Cholesky One S.D. Innovations ± 2 S.E.

Response of LRM to RBD Response of LRM to LRM
.3 .3

.2 .2

.1 .1

.0 .0

-.1 -.1

-.2 -.2
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Response of LRM to LCPI Response of LRM to LREXC

.3 .3

.2 .2

.1 .1

.0 .0

-.1 -.1

-.2 -.2
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Response of LRM to LRGNP

.3

.2

.1

.0

-.1

-.2
1 2 3 4 5 6 7 8 9 10

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 Figure 2: Reponses of variables to LRM

Response to Cholesky One S.D. Innovations ± 2 S.E.

Response of LRM to LRM Response of RBD to LRM
.5

.4 200

.3

.2 100

.1

.0 0

-.1

-.2 -100
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Response of LRGNP to LRM Response of LREXC to LRM

.15 .3

.2
.10

.1
.05
.0
.00
-.1

-.05
-.2

-.10 -.3
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

Response of LCPI to LRM

.2

.1

.0

-.1

-.2

-.3

-.4

-.5
1 2 3 4 5 6 7 8 9 10

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 Table 7: Variance decomposition of LRM

Period S.E. LRM RBD LRGNP LREXC LCPI

1 0.067094 100.0000 0.000000 0.000000 0.000000 0.000000

2 0.090761 96.70344 0.429796 0.640685 1.938712 0.287368
3 0.122525 84.12811 3.408137 2.704859 8.780746 0.978151
4 0.166507 77.07742 12.15537 2.195328 7.718755 0.853123
5 0.207830 76.59623 14.80543 1.604268 6.445138 0.548942
6 0.243420 76.55278 13.92565 1.423258 7.666455 0.431859
7 0.280046 75.49948 13.78957 1.127054 8.823011 0.760884
8 0.317719 75.29333 14.38963 1.151059 8.234375 0.931598
9 0.352810 76.32315 14.13642 1.055157 7.695890 0.789380
10 0.388073 76.81137 13.43376 0.972987 8.095187 0.686696

table 8: Variance decomposition of RBD

Period S.E. LRM RBD LRGNP LREXC LCPI

1 60.06198 9.234208 90.76579 0.000000 0.000000 0.000000

2 76.94847 35.47128 56.21581 0.103160 0.054813 8.154933
3 86.07209 46.72801 45.99049 0.105750 0.053961 7.121794
4 94.99078 48.12804 38.10559 6.364510 1.461906 5.939949
5 108.2915 50.63771 35.52844 7.971200 1.287126 4.575515
6 122.8400 56.98766 31.22512 6.353431 1.312968 4.120824
7 137.8894 61.38082 26.71971 5.159558 3.368385 3.371528
8 156.0190 63.03477 23.81525 4.042444 6.058828 3.048709
9 176.2616 64.80992 22.74274 3.193021 6.352386 2.901936
10 195.5361 67.78444 20.95550 2.595927 6.268230 2.395910

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 CONCLUTION

The purpose of this study was to find the relationship between money demand and budget deficit.

It is received from the cointegration test that there is long run relationship between money demand,

budget deficit, cpi, gnp and exchange rate. The signs of all the variables in long run correspond

with theory. Budget deficit has positive impact on M2 corresponded with Keynesian-Neoclassical

theory, so government’s bonds is a part of the wealth of households. The error correction term is -

0.33 that indicate it takes 3 years to reach equilibrium. In short run budget deficit is the granger

causality for M2 but this causality isn’t bilateral. The impulse response and variance

decomposition imply the duration of significant response of budget deficit to real money demand

is the most among all variables. It is obvious that budget deficit is an effective variable in long

run, short run granger causality, impulse response and variance decomposition, so policy makers

should pay more attention to the role of budget deficit on money demand and the whole economy.

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from Lebanon Middle Eastern Finance and Economics, Issue 3”

http://www.cbi.ir/

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