Testing the Endogeneity of Money in Iran's Economy

Endogenous money theory is one of the Post Keynesian cornerstones that contrary to mainstream monetary theory, emphasizes on the importance of bank loans causing money supply changes. In fact, the direction of causality in endogenous money supply theory is from loans to money. In contrast, in the exogenous money theory, it is money that forms loans. Endogeneity or exogeneity of money, will change our view to appropriate monetary policy tools. Post Keynesians have developed the view that pressures emerging endogenously within financial markets are the basic determinants of both fluctuations in money supply growth and of credit availability. The orthodox monetary approach presents a direct contradiction to the endogenous money hypothesis.
The money supply endogeneity views are generally divided into two: the accommodationist view and the structuralist view. The accommodationist view argues that aggregate demand needs expressed through demand for credits cause a passive response of the financial institutions and authorities. In other words, banks set their loan rates as a mark-up over the overnight interest rates determined by the central bank (CB) and attempt to meet all demand for bank loans. Therefore, demand for bank loans is determined by working capital finance needs of firms. This implies that money supply (M1, M2) is determined by the demand for bank loans (bank credit, BC).
Compared to the accommodationist view, the structuralist approach argues that the CB is also a significant factor since it can restrict accommodation of reserve needs and restrict credit expansion. As a result, the CB can alter the amount of bank credits. In statistical terms; this implies that monetary base (MB) can cause bank credit (BC). Thus, there is a two-way relationship between BC and MB.
The alternative money endogeneity views indicate the following hypotheses that can be investigated empirically. The accommodationist view argues that there is an unidirectional relationship from bank credit (BC) to the monetary base (MB) and the monetary aggregates (M1,M2). Moreover, the relationship between money income (GDP) and monetary aggregates, (M1,M2) is bidirectional. The structuralist view proposes a mixed empirical model with accommodationist view and the monetarist approach. Specifically, a feedback relationship is proposed between monetary base (MB) and bank credit (BC). The structuralist view agrees with the accommodationist view on the relationship between income and monetary aggregates which implied a bidirectional relationship between income (GDP) and monetary aggregates (M1, M2).
Previous empirical studies on the endogeneity of money implement different causality techniques (Granger causality tests, cointegration and error correction models, etc.). All of these methods test the causality between bank credit and different monetary aggregates from a time series perspective. In other words, the relationship between lagged values of bank credit and money is analyzed. These time-series methods have several significant limitations. First of all, the results highly depend on lag selection. Second, in some cases (like cointegration tests), they only measure whether two variables move together over time. Thus, they do not directly test causality but they are approximate tests of the relationships. Third, the causality tests do not present the sign of the correlation between two variables. In other words, whether the relationship is negative or positive cannot be identified by the causality tests. Finally and most importantly, they do not investigate contemporaneous relationship between variables and are limited to causality between a variable and lagged values of other variables.
The direct test of endogeneity of money uses the econometric definition of endogeneity and implements tests developed to test endogeneity empirically. In the econometric theory literature, endogeneity is explained as the case when the independent variable is correlated with the error term in a regression model. A regressor is endogenous if it is not predetermined (i.e., not orthogonal to the error term), that is, it does not satisfy the orthogonality condition. Following this argument, we test whether money is endogenous using the C statistic (difference-in-Sargan statistic), Durbin statistic or Wu-Hausman statistic, depends on instrumental variable estimation method.
We used two different time frequency (annual and seasonal) and two different dependent variables (LBC: Bank Credit in Logarithm form & LSBC: Bank Credit Stock in Logarithm form) to test the endogeneity of money (LMB, LM1, LM2; Money Base, M1, M2 in Logarithm form). The results are summarized in following table: frequency Independent variable Dependent variable: LSBC Dependent variable: LBC
C statistic Durbin statistic Wu-Hausman statistic C statistic Durbin statistic Wu-Hausman statistic
annual LMB 0.10 0.24 0.02 0.228 0.0638 0.056
LM1 0.16 0.03 0.26 0.025 1.72 1.63
LM2 0.548 0.634 0.573 1.46 2.86* 2.85
seasonal LMB - - - 0.14 11/0 0.11
LM1 - - - 0.73 3.28* 3.28*
LM2 - - - 6.3** 5.2** 5.2**
* Exogeneity (null hypnosis) can be rejected in 10% significant state
** Exogeneity (null hypnosis) can be rejected in 5% significant state
When dependent variable is LSBC and we use annual data the minimum P-value is 0.43 (for Durbin statistic when independent variable is LM2) and we cannot reject null hypnosis of exogeneity. With seasonal data, also, the null hypnosis can’t be rejected (coefficient are not reported). By changing the dependent variable to LBC we observe that with annual data the exogeneity of liquidity (M2) can be rejected in 10% significant state, only by Durbin statistic. With seasonal data and based on all statistics, M2 can be interpreted as endogenus variable but exogeneity of LMB and LM1 cannot be rejected yet.
These results can change this view that “money supply cant be used as a monetary policy tool and interest rate is the appropriate of monetary policy tool in Iran's Economy". Thus, money supply could be an effective monetary policy tool and central bank can use it with more efficiency than interest rate.