Money Supply Endogeneity: An Empirical Test for the United States, 1954-84
The endogeneity or exogeneity of the money supply process is an issue of central importance to a proper formulation of macroeconomic theory and policy. Despite an extensive literature debating this question in theory, there has been very little work done addressing the question of whether the money supply process is endogenous in fact. This represents a gap in the literature for two reasons. First, while the literature discusses theoretical issues ranging from the degree of interest sensitivity, and the degree of interdependence between money supply and demand, to the stability of the velocity of circulation, the vital issue is the direction of causation.' Second, tests of causality have been proposed and extensively applied in other contexts. Christopher Sims [1972] was one of the first to propose a technique for testing uni-directional causality in a bi-variate system. He applied his test to quarterly U.S. data on nominal incomes and money, and concluded that causality flowed uni-directionally from money to nominal income. He found no evidence to suggest reverse causation from income to money. However, there have been no attempts to replicate Sims's study using U.S. data and other variables besides income.2 Moreover, as is well known, bi-variate tests may suffer from omitted variable bias. As yet there have