ΣΠΟΥΔΑΙ / SPOUDAIΕΤΟΣ 1993 ΙΑΝ. - ΜΑΡΤΙΟΣ ΤΟΜΟΣ 43 ΤΕΥΧ. 1

YEAR 1993 JAN. - MARCH VOL. 43 No 1

THE ACCOMMODATION HYPOTHESIS IN GREECE.

A TRI-VARIATE GRANGER-CAUSALITY APPROACH

ByAnastasios G. Karasawoglou Konstantinos P. Katrakilidis

andTechnological Educational University of Thessaloniki

Institute of Kavala.

Abstract

This paper with title "The Accommodation Hypothesis in Greece. A tri-variate Granger-Causality

Approach" investigates empirically the causal relationship between money growth, budget deficits and

inflation in Greece employing a tri-variate error-correction model. The causal relationship between

money, deficits and inflation is explored using three alternative definitions for money: high-powered, M l

and M2 definitions of money stock. The results support the accommodation hypothesis and provide

evidence that deficits are inflationary when monetized. (JEL E58)..

1. Introduction .

Large budget deficits —according to the popular view— contribute to exces-sive money growth, high interest rates and inflation. A number of theoreticalalternative hypotheses, regarding the relationship between budget deficit andmoney growth, has been developed. First, is the accommodation hypothesis;large deficits pull upwards interest rates and thus cause the monetary authoritiesto monetize the debt in order to keep interest rates stable. Second, is the reversehypothesis that money growth causes budget deficits (Barro, 1979); excessivemoney growth, results in inflation which causes the government to increasenominal deficits, in order to keep up with the rate of inflation. Third, is theassumption that there may exist two-way causality between deficit and money

* We thank Prof. A. Lazaridis and Prof. G. Katsimbris for detailed and valuable comments.

We also acknowledge the helpful comments of Prof. E. Dinopoulos and Lectures C. Karfakis, N.

Varsakelis and G. Papachristou. We are very grateful as well to an anonymous referee for his/her

numerous invaluable comments on the first draft of our paper. All errors are our responsibility.

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growth. These feedback effects appear either directly or indirectly through thechannel of interest rates and inflation. Such a consideration implies that, studieswhere either money or deficit is treated as an exogenous variable are subject tosimultaneous-equation bias. Finally, there is the assumption that there is nocausal relationship between budget deficits and money growth; any observedcorrelation may be spurious due to their correlation with a third variable(s).

The literature concerning the empirical analysis of the relationship betweenmoney growth and deficits, can be broadly classified into three categories: a)studies based on the estimation of a single reaction function of the central bank(Niskanen, 1978; Hamburger ans Zwick, 1981; Allen and Smith, 1983; King andPlosser, 1985; Joines, 1985; Grier and Neiman, 1987; Koluri and Giannaros,1987); b) studies where the reaction function of the central bank is estimatedwithin a system of equations (Button, 1971; Levy, 1981; Dornbush and Fisher,1981; Demopoulos, Katsimbris and Miller, 1987; Turnovsky and Wohar, 1987;Landon and Reid, 1990; Burdekin and Wohar, 1990) and c) causality studies(Dwyer, 1982 and 1985; Ahking and Miller, 1985; McMillin, 1986; Protopapa-dakis and Siegel, 1987; Barnhart and Darrat, 1988 and 1989;).

The reported results from all those empirical studies are rather mixed. Forexample, Akhtar and Wilford (1979), Hamburger and Zwick (1981), Levy(1981), McMillin (1986), report that deficits Granger-cause money growth. Onthe other hand, Niskanen (1978), Dwyer (1985), Joines (1985), Koluri and Gian-naros (1987), Barnhart and Darrat (1988, 1989) and Landon and Reid (1990)conclude that money growth does not appear to be determined by deficit financ-ing. In the studies of Barro (1979) and Bradley and Potter (1986), the evidence isthat money growth causes deficit increases. Other studies, conclude that theinvestigated relationship becomes either significant or insignificant, dependingon the subperiod examined (Turnovsky and Wohar, 1987; McMillin, 1986; Lan-don and Reid, 1990) and on the exchange rate regime (Demopoulos, Katsimbrisand Miller, 1987).

This paper investigates empirically the causal relationship between moneygrowth, budget deficits and inflation in Greece for the period 1958-1990,employing a tri-variate error-correction model and using three alternative defini-tions for money; i.e. high-powered, Ml and M2 definitions of money stock. Theresults suggest that the variables under investigation are cointegrated and thatthere exists a two-way causal relationship between budget deficits, and high-powered money and Ml. Furthermore, there is also one-way causal effectsrunning from M2 to deficits. Inflation is found to be Granger-caused by moneygrowth, that is, deficits are inflationary in Greece when monetized.

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The remainder of the paper is organized as follows: Section II, outlines thecointegration and error-correction techniques. Section III presents the data andthe empirical findings. And section IV presents a brief summary with concludingremarks.

3. Data and Empirical Findings

The empirical analysis1 uses annual data2 for the period 1958 to 1990. Wehave examined the dynamic interactions between money and deficit in a tri-variate system, consisting of the Consumer's Price Index (PC), as a measure ofthe general price level, the Central Government Budget Deficit (DEF) and threealternative proxies for the money series; high-powered money (HM), the narrowMl definition of money (Ml) and the M2 definition of money (M2). All dataseries are in natural logarithms.

In order to remove any deterministic non-stationarity in the system alongwith troublesome outliers and regime shifts that occured over the sample period,we keep into the analysis a constant term in all the equations and we incorporatetwo properly specified dummy variables3, as well as a linear time trend variable.Thus, DUMP takes account of the residuals outliers in the price level eqaution,DUMD takes account of the outliers in the deficit equation and T takes accountof the linear time trend.

Our research, proceeds in two stages . First, we test for cointegrationbetween deficit, price level and the three alternative measures of the moneyvariable. Next, if cointegration is detected, the error-correction model of equa-tion (2) is estimated; on the other hand, for the variables which are not cointe-grated we estimate equation (2) after deleting the lagged error-correction term.

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3.1. Cointegration Tests

Since cointegration requires non-stationary data-series of the same order ofintegration, we first test for stationarity using the Dickey-Fuller (DF) and aug-mented Dickey-Fuller (ADF) tests. The results, presented in table (2), suggestthat all variables are non-stationary in levels whereas they are stationary in firstdifferences, at the 5-percent level of significance.

Having determined that the series are first-differenced stationary, that isthey are integrated of order (1), we proceed to test for cointegration. We appliedordinary least squares (OLS) on model (3) and examine the residuals for station-arity. If the residuals are stationary then the series in the OLS regression arecointegrated, which means that there exists a stable long-run relationshipbetween them. The findings are presented in table (3). Reported DF tests rejectthe null hypothesis for non-stationary residuals at the 5-percent level of signifi-cance and thus the evidence suggests cointegration between the three examinedvariables. Next, we proceed to detect the directions of the causal effects.

3.2. VAR and Error-Correction Modeling

Since deficit, price level and money series are cointegrated, we examine thedirections of the causal effects within an error-correction framework. Weemploy three-equations systems, where each system incorporates one of thethree alternative money proxies, thus allowing us to treat each variable asendogenous.

The autoregressive lags for all the variables have been determined optim-ally, in a previous stage, using the Final Prediction Error (FPE) Criterion andfollowing Hsiao's methodology as extended by Ahking and Miller. The FPEvalues have been calculated for lag lengths varying from 1 to 4 years and arereported in table (1).

The final specification of the three-variate autoregressive models given byequation (2), incorporates two dummy variables denoted by DUMP and DUMDas well as a. linear time trend variable T. Dummies and trend variable areproperly defined to remove non-stationarities in the system..

Furthermore, the current values of the endogenous variables included in theerror-correction models allow to examine for contemporaneous relationshipsamong the variables. Estimation results are based on Seemingly Unrelated

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Regressions (SUR). Granger-Causality inferences are derived using X2-statisticto test the null hypothesis that particular terms are excluded. Inferences concern-ing contemporaneous causality as well as Granger-Causality emerging throughthe lagged error-correction term are based on t-tests of the null hypothesis thatthe respective coefficients are statistically zero. Tables (4), (5) and (6) present theresults of the tested hypotheses while each table refers to one of the threeequation-systems we estimated in order to examine all different proxies for themoney variable.

The evidence from table (4), concerning the causal relationships betweenhigh-powered money, price level and budget deficit, during the period 1958-1990, supports the following inferences: budget deficit is caused instantaneouslyby inflation while causal effects emerge as well through the significant error-correction term of the first equation.

It is widely accepted that the relationship between budget deficit and moneygrowth is best addressed by examining high-powered money. If the Central Bankmonetizes the deficit, it expands high-power money which has to be highlycorrelated with Ml if the money multiplier is stable.

"Although based on the above thoughts, we expected to find a causal rela-

tionship running from deficit to high-powered money, results revealed lack ofcausality in any direction between the two variables6. Thus, in order to obtainfurther insight, we checked for a structural break during the employed sample.From 1986, Treasury Bills and Treasury Bonds become the main source offinancing deficits. This, together with interest rates deregulation contitute aradical change for the Greek Banking System and thus 1986 may be consideredas a breaking-date and has to be used to check the structural stability of theestimated equations. The very limited number of observations after 1986, makesimpossible the use of the widely known Chow test for structural stability. Thuswe re-estimate the system of equations using data from 1958 to 1986. The resultsconcerning the relationships between the examined variables in the period 1958to 1986 are presented in table (4) together with the results concerning the wholesample, that is, from 1958 to 1990.

Based on the new findings, we conclude the existence of a two-way causalitybetween high-powered money growth and budget deficits while high-poweredmoney Granger-causes inflation.

Table (5) presents the results concerning the second equation-system withMl as the appropriate money variable. The outcome supports the existence of a

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two-way causality between deficit and Ml growth, as well as instantaneousfeedback effects between Ml growth and inflation. The above inferences holdfor both sample periods, 1985-1986 and 1958-1990.

The findings from the third equation-system are reported in Table (6) andconcern the causal relationships between price level, budget deficit and the M2measure of money. The results indicate, for both samples, uni-directional causal-ity running from M2 and inflation to deficits while between M2 growth andinflation exist feedback effects.

In sum, considering all the money proxies used and comparing the resultsfrom the three estimated systems in both sample periods, yields the following,theoretically consistent inferences. First, there is a stable long-run relationshipbetween deficit, price level and money, no matter the employed definition formoney. Second, two-way causal effects are detected between deficit, and high-powered money and Ml while a one-way causal relationship runs from M2 todeficit. Third, all definitions of money growth cause inflation to increase. Andfourth, 1986 has been correctly used to check for a structural change since itrevealed that high-powered money used to be significantly Granger-caused bydeficits till 1986.

4. Concluding Remarks

This paper examines the causal relationship in the Granger sense, betweenbudget deficits, inflation and money growth, with special reference to the case ofGreece, employing a tri-variate error-correction model. Money is measuredusing three alternative definitions: high-powered money, Ml and M2 definitionsof money stock. The findings support the existence of a stable long-run relation-ship between the investigated variables and the causal effects are found to beaddressed as follows: A two-way causal relationship exists between deficit, andhigh-powered money and Ml, as well as a uni-directional causal relationshiprunning from M2 to deficit. Last, money growth is found to Granger-causeinflation.

Therefore, our analysis supports the accommodation hypothesis for Greeceand provides evidence that deficits are inflationary if they are monetized.Finally, the above findings reveal the interdependence of monetary and fiscalpolicy in Greece.

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