Granger-Causality Between Inflation, Money Growth, Currency Devaluation and Economic Growth in Indonesia, 1951-2002

This paper uses annual data for the period 1952-2002 to investigate the inflationary process in Indonesia within the cointegration and Granger´s causality framework. The empirical results suggest that the consumer price index (CPI), the stock of narrow (M1) or broad money (M2) and real permanent income form a weakly cointegral relationship for the complete sample period. This relationship remains broadly stable for several sub-samples, especially when the model is estimated with the narrow definition of money. Three testable hypotheses in particular are investigated: (1) Does the money supply growth Granger-cause inflation? (2) Does currency devaluation Granger-cause inflation? (3) Does inflation affect economic growth? The empirical results suggest that in Indonesia, there existed a bi-directional causality between money supply growth and inflation and between currency devaluation and inflation. For the complete sample period, the causality running from inflation to narrow money supply growth was stronger than that from narrow money supply growth to inflation. This result is consistent with the view that in high-or hyperinflationary economies, inflation does have a strong feedback effect on money supply growth and this generates a self-sustaining inflationary process. The bi-directional causality between currency devaluation and inflation was, however, weak or not so robust for the complete or any shorter sample period. On the relationship between inflation and economic growth, the results suggest that there was no causality from inflation to economic growth for the complete or any sub-sample period.