Does Money Matter in Canada?

Evidence from a Vector Error Correction Model Author(s): Steve Ambler Reviewed work(s): Source: The Review of Economics and Statistics, Vol. 71, No. 4 (Nov., 1989), pp. 651-658 Published by: The MIT Press Stable URL: http://www.jstor.org/stable/1928107 . Accessed: 13/03/2012 20:36
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DOES MONEY MATTER IN CANADA? EVIDENCE FROM A VECTOR ERROR CORRECTION MODEL
SteveAmbler*
clude that firstdifferencing data entails a the specification error.Sims (1980) foundthatadding interestrates to estimatedvector autoregressive (VAR) systemsreducedthe statistical importance of the money stock, but Littermanand Weiss (1985) found an increasedrole formoneyby including a quadratic timetrendalong withinterest rates in a VAR model. The presentpaper uses modern techniquesto investigatethe statisticalpropertiesof a set of I. Introduction Canadian and U.S. economictimeseries,and uses UNTIL recently, statistical inference eco- thedata to addressthequestionof theimportance in nomic time serieshas oftenbeen conducted of money in Canada. Using monthlydata from underthe assumption thattheseriesare stationary the floatingexchange rate period, it is demonafterremovinga deterministic trendcomponent. strated that the individual series are consistent Recent evidenceby Nelson and Plosser(1982) and with the hypothesisthat theycontain stochastic but stationary. study others has called this assumptioninto question trends are first-difference The and has shown that if the trendcomponentsof also finds evidence for the existenceof several relationships (co-integrating vectors, cf. economic time series also contain stochasticele- long-term the ments, this can have important implicationsfor Granger and Engle (1987)) that tie together many questionsin macroeconomics. Misspecifica- levels of the series. mechanism(VECM) tion of trend componentscan lead to incorrect A vectorerrorcorrection of representation the data (cf. Grangerand Engle testsof macroeconomic theories. One important for (1987)) is specifiedwhich takes into account the questionin macroeconomics in estimates which the specification trends of has been empiri- relationships the levels.The resulting in are used to conduct Grangercausalitytests.Eviis cally important thatof abilityof movements in dence is foundthatmonetary variableshave premonetaryvariables to help predictmovements real output. As Stock and Watson (1989, p. 161) dictive content for Canadian output; lagged note, "researchers using only slightlydifferent changes in Canadian velocityare statistically sigdif- nificant the Canadian outputequation. in specificationshave reached disconcertingly ferent conclusions using postwar U.S. data." The paper is organizedas follows:in thesecond Eichenbaum and Singleton(1986) found that the section,the stationarity of properties the individof statistical importance moneywas reducedwhen ual series are examined.The followingtwo secstatisticaltests were performed using the log dif- tions proceed in a mannerakin to the two stage of ferences variablesas opposed to log levelswith estimationproceduredescribed by Granger and a time trend. Christianoand Ljungqvist(1988) Engle (1987). The thirdsection describesthe rethe investigate potentialcauses forthisdifference sultsof a searchforlong-run relationships among and con- the variablesof the study.The fourth sectionuses using bootstrap simulationexperiments these long-runrelationshipsto estimatevarious Received forpublicationJune6, 1988. Revisionaccepted for specifications vector errorcorrectionmodels, of publicationJune12, 1989. and reportsthe resultsof the Grangercausality *Universite Quebec a Montreal. du The author would like to thank Emanuela Cardia, Pierre tests.The resultsare compared withtestsfroma anony- VAR model estimatedusing the log levels of the discussions, three Perronand Louis Phaneufforhelpful and the Social Sciences mous refereesfor helpfulcomments, series. The fifthsection summarizes and conand Humanities Research Council of Canada for financial cludes. support.The usual caveat applies.
Abstract-This paper investigates statistical the properties a of set of Canadian and U.S. economic time series and uses the data to address the question of the importanceof monetary variables in Canadian businesscyclefluctuations. individThe ual time series are found to contain unit roots,but the data reveal the existence of several economicallymeaningful cointegrating vectors. multivariate A vector error correction model (VECM) is estimated, and Canadian velocity, whichappears as an errorcorrection term, significant the Canadian output is in equation. This supportsthecontention thatmonetary variables have predictive contentforreal output. Copyright 1989 ?M

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TABLE 1. -UNIT ROOT TESTS (LEVELS)

on a linear timetrend, The level of each variablewas regressed a constant, deterministic parameter and the lagged level of the variable.Results are reportedfora lag truncation equal to 12. Variable: U.S. money U.S. interest rate U.S. output U.S. prices Cdn. money Cdn. interest rate Cdn. output Cdn. prices Exchange rate
aSignificantat 5%. at bSignificant 1%.

a 0.906 0.946 0.880 1.012 0.939 0.984 0.559 1.006 0.935

Z(a) -14.02 - 9.65 -23.91a -0.45 -6.45 - 5.94 -124.76 - 2.24 - 13.27

Z(t,) - 2.42 - 2.10 -3.64a -0.17 -2.01 - 1.47 -8.70b - 0.74 - 2.89

Z(D3) 3.50 2.31 6.70a 0.72 3.58 1.43 0.46 4.26

37.91b

II.

The Time Series Properties of theIndividual Series

The data set used in the study consists of U.S. and monthlyobservationson the following Canadian variables: interest rates, consumer as production a proxyforoutput, prices,industrial money supplies and the bilateral exchange rate (see the appendix for details). The sample was exchangerateperiod(July to restricted the flexible tests (not reported) 1970 onwards). Preliminary suggestedbreaks in severalof the Canadian series rate period.Also, at the beginningof the floating capital mobility suggeststhatunderperfect theory policyis comand fixedexchangerates,monetary even whenpricesand wages are pletelyineffective contentof monerigid. The statisticalpredictive tary variables may be obscured if data fromthe fixedrate period are included. U.S. variableswereincludedsinceit is clear that events south of the borderare a major factorin (1) y, = ti + p(t - T/2) + ay,-, + u, generating Canadian business cycles. Omitting Table 1 reportsthe estimatedvalues of a and biases when the statisticsZ(a), Z(ta) and Z(D3) (definedin U.S. variables could cause important of analyzingthe effects Canadian variables.Since Perron's paper) which test respectively the null it is also clear that the influenceof events in hypothesesa = 1; a = 1; and /3 0, a = 1 for = Canada on the U.S. business cycle should be of the levelsof the series.2The statistics also depend includingU.S. variables in the on a truncation little importance, 1. parameter, Thereis some ambimodel misspecifica- guityconcerning study is useful for detecting the proper choice of 1. Results tion. are reportedhere for /= 12, but therewere no The first step in the studywas to conductunit substantialdifferences (except forU.S. output,as root tests on the individualseries.Perron(forthshownthat testsof this hy- 'Paquet (1988) uses this technique to test for structural coming) has recently rate pothesis are sensitiveto the allowance for struc- breaksin U.S. and Canadian real interest series. 2 Criticalvalues testscan be foundrespectively the turalbreakswithin sampleperiod.By allowing in Fuller (1976, p.forthe three(1976, p. 373) and Dickey and 371), Fuller that coincides with the Fuller (1981, p. 1063). for a change in intercept

Great Depression and for a change in slope that coincideswiththe first OPEC oil shock,he shows thatit is possible to rejectthe null of a unit root for most U.S. time series, in contrast to most previousstudies.Plots of the recursive first order sample autocorrelations each of the series reof vealed no potentialstructural breaks in the data set used in thisstudy.' The unitroot testsperformed hereare based on work by Phillips (1987) and Phillips and Perron (1986), whichis summarized Perron(1988). The in Phillips-Perron accounts forpossible correlatest tion in the first of differences the timeseriesusing a nonparametric correction, and allows for the presenceof a non-zeromean and a deterministic lineartimetrend. Following the strategysuggested by Perron (1988), thetestsare based on ordinary leastsquares of (OLS) estimates the following equation:

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to This explained below) for /= 1 and 1 = 4. For all of refer theproblemas overdifferencing. secof to the seriesexcept forCanadian and U.S. industrial tiondescribestheresults an attempt uncover output,the resultsindicatethatit is impossibleto long-runrelationshipsamong the series of this reject the null hypothesisof a unit root at a study. Following Granger (1986) and Granger and level of 10%. significance of The resultsare ambiguousin the case of U.S. Engle (1987), a seriesis called "integrated order and integrated of industrialproduction.Depending on the trunca- zero" or I(0) if it is stationary, d tion parameter and the particulartest statistic order d or I(d) if it needs to be differenced 2.5%, 5% timesin orderto be made stationary. Given two is considered,thelevelof rejection either is or 10%. The unitroothypothesis rejectedin the timeseriesxt and ytthatare I(1), if thereexistsa case of Canadian industrialproduction.3How- constantA such that ever, indirectevidence will be presentedin the (2) zt = yt-Axt that suggests followingsection on co-integration that a case can be made thatCanadian industrial is I(0) then the series are to be co-integrated. Here, A is unique and the relationship = Axt outputis also nonstationary. yt Perron notes that the failureto rejectmay be can be thought as a long-run of relationship beof the due to the poor power properties the statistics tween x and y, with zt measuring divergence this relationship. vector - A] The [1, timetrendis includedin the from long-run when a deterministic vector, and is unique If regression. thenull of a unitrootis accepted,he is knownas a co-integrating elementis normalizedto equal that given thatits first suggestsa test of the joint null hypothesis the one. = a = 1, M= 0, /3 0. If thiscannotbe rejected, When more than two I(1) variablesare considwithout timetrend, the model can be reestimated and testsof the threenull hypotheses Ho: a = 1; ered, the situation becomes more complicated. = aH xx 1; and H3: M= 0, a = 1 can be per- Given n I(1) timeseries,thentheseriesare said to of formedwiththe new model. It was neverthe case be co-integrated orderr if thereexistsan n X r forthe data set used herethatdroppingthedeter- matrix8 such that and allowed ministic timetrendwas bothjustified (3) zt= 8 x the null to be rejectedwhen it would otherwise is an r-vectorof time series that are all I(0). have been accepted. it differences Unfortunately, is difficult give an economic to The testswere repeatedforthe first to This is relationships. of the series (resultsnot shown). In all cases the interpretation thelong-run vectors8 is null hypothesisof a unit root is rejectedat the because the matrixof co-integrating for not unique. For any r x r matrix0 of fullrank, were much stronger 10% level. The rejections of vectors of the firstdifference industrialoutput than for 68' willalso be a matrix r co-integrating for xt. In other words, linear combinationsof the level. vecvectorsare also co-integrating co-integrating tors. Relationships III. The Search forLong-run Several different are available to atstrategies Althoughindividualseriesthatcontainstochas- temptto uncoverlong-run in relationships a set of in tic trendsare nonstationary theirlevels,if the timeseries.One strategy describedin Grangerand stochastictrendsare common across series there Engle (1987) and elsewhere consistsof estimating of will be stationary linearcombinations the lev- co-integrating leastsquares regressions ordinary by is els. This phenomenon knownas co-integration.4using subsets of the series. Given that thereare A statisticalmodel that omits these relationships nine variablesin the presentstudy, numberof the is misspecified; Stock and Watson (1989, p. 161) possible regressions subsetsof these seinvolving ries was too large to be practical. 3Inspection of a plot of thisserieswould reveal thatgrowth A second possible strategy consistsof estimathas production been quite flatsince the in Canadian industrial of oil first price shock,even comparedwithoverallGNP growth. ing the principalcomponents the series.Princiinclude pal components, 4Theoretical and empiricalstudiesof co-integration which are constructed using the Granger (1986), Hall (1986), Hendry (1986), Granger and of eigenvectors the sample momentmatrixof the Engle (1987), King, Plosser,Stock and Watson (1987), Stock series, are mutuallyorthogonalby construction. and Watson (1988, 1989).

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Their sample variancesare equal to the size of the significance the error correctionterms were of correspondingeigenvalues of the data moment unaffected. matrix. Principal components associated with Given thatthe main goal of thepresent studyis varismall characteristic rootsimplythatthereare "al- to assess the predictive contentof monetary most" exact linear relationships among the series, ables forreal output,it was decided to use a third A the are strategy identify to vectors. priori and therefore corresponding eigenvectors co-integrating naturalcandidatesforco-integrating vectors. Tests reasoningwas used to searchforlinearcombina(not reported here) show that it is possible to tions of the series with economically meaningful of In reject the null hypothesis a unitroot forsix of interpretations. table 2, resultsare shown for the nine principal componentsof the variables Phillips-Perrontests on six such combinations. rate difused in this studyusinga Phillips-Perron and Canadian velocity,the nominal interest test betweenCanadian and theUnited States, for the criticalvalues establishedby Dickey and ferential measures of the differential Fuller (1981). These resultsare suggestive rather and three different than conclusive given that the correctprocedure between Canadian and U.S. real income were all would involve testingthe hypothesessimultane- found to be strongly stationary. U.S. velocity was found not to be stationary, a gridsearchover but ously ratherthan sequentially. on rate yieldeda Stock and Watson (1988) use principalcompo- coefficients the nominalinterest nents to develop severaldifferent versions such vector which allows rejection of the unit root of a test. The test was implemented the version hypothesisat the 1% level. The vector has the for of which relies on a nonparametric correctionfor interpretation a long-rundemand for money in serial correlation the residuals, whichis closest function.Engle and Yoo (1987, p. 152 ff.)note vectors in spirit to the Phillips-Perron tests used in the that when the elementsof co-integrating of previous section.5The null of fiveco-integrating are estimated,the large sample properties the and otherstatistics vectorsversus the alternative six was soundly t-statistic of depend on the numrejected for a wide range of the lag trunca- ber of estimatedcoefficients. However, the unit tion parameter.' The test of six versusseven co- root hypothesisis rejected for the long-rundeeven given the adjustintegrating vectorsturnedout to be sensitiveto mand for money function coefficient.7 the choice of the lag truncation parameter.For mentforthe singleestimated values of the parameter equal to 1, 4, 6, 12 and 24 Two of the transformed series(the interest rate the calculated statistictook on values of - 37.9, differential the uncorrected and real income difare variables -34.9, -35.4, -44.4 and -56.1, respectively. ferential) similarto the transformed Accordingto table 3 of the Stock-Watson paper, in a recentstudyby Backus (1986). He uses the the first threestatistics significant only the differences are at betweenU.S. and Canadian variables 10% level.The fourth significant 2.5%, and in " primarily detrending is at as devices," but does no the last case the marginalsignificance level drops formaltesting the unit root hypothesis his of for of series.In fact,it was not possible to below 1%. Given theambiguity theseresults, all transformed of the errorcorrection for estimatesof the following rejectthe unit root hypothesis the price level and section were redone adding an additional error differential the moneystockdifferential. It is interesting note that while Canadian withthe to correction term(the principal component on smallestsample variance).The results all of the velocityis stationary the basis of the Phillipsof outputwas Granger causality tests as well as the statistical Perrontests,whenCanadian industrial excluded fromthe co-integrating vectorit was not If possible to rejectthe unit root hypothesis. real balances are nonstationary while velocityis sta5 Stock and Watson suggestseveraldifferent (asymptotically equivalent) ways of proceeding.Here, the series were first tionary, mustnecessarily thecase thatindusit be detrended and adjusted for theirsample means. Stock and trial output is I(1). Similarly,when Canadian Watson note that thereare several possible choices for the income "time domain kernel" used to calculate the nonparametric output was excluded fromthe different
correction.The one used here was suggestedby Newey and West (1987), and is recommended Perron (1988) in the by univariatecontext. 6 The statistic was significant the1% level forvalues of the at parameterof 1, 4, 6, 12 and 24. vectors involve several 7Although the other co-integrating are variables,the coefficients imposed on the basis of theory. As Engle and Yoo (1987, p. 152) note,in thiscase theproblem process." "becomes simplya testforunit root in a univariate

DOES MONEY MA7TER IN CANADA?

TABLE 2.-UNIT ROOT TESTS ON COINTEGRATING VECTORS

655

vectorwas regressed a constant, deterministic on a Each co-integrating linear timetrend, vector. Results are reported for a lag and the lagged level of the co-integrating truncation parameter equal to 12. Variable: (y + p - m)
(i - i*) + p) (y - y* + e -p (y* + p* - .014i* (y - y*) (y - y* + e)

a 0.448
0.834 0.734 0.513

Z(a)
-141.12a -33.90a -55.20a -58.05 -88.42a -55.98a

Z(ta) -9.48a -4.24a -5.71a _ 5.73b -7.87a

3)

0.734 0.726

44.92a 9.05a

16.31a
16.57b 30.98a 17.14a

-5.85

Note: Variables are defined in the data appendix. bSignificantat 5%. bSignificancelevel discussed in text.

was differential measures,theunitroothypothesis accepted. Given thisindirect evidence,it was dewithall cided to estimatea vectorautoregression variables in firstdifferences all of the series, of includingindustrial output, and withthe six series vectorsas generatedby the a priorico-integrating additional explanatory variables. IV. The VectorErrorCoffection Estimates

Granger and Engle (1987) show that for time series that are 1(1) but which have common stochastictrends,so that thereare one or more vectorsthatlinkthe series,themulco-integrating tivariate data generating processhas a vectorerror correction This can be written as:8 representation. A(L)Ax, = yS'x,_1+ d(L)6t (4) wherex is the n-vector variablesin the model, of operator,8 is the n x r A is the firstdifference matrix of co-integrating vectors,y is an n x r matrixof coefficients, A(L) and d(L) are matrix polynomialsin the lag operatorL with A(O) = I, and Et is a zero-mean n-vectorof white noise disturbances. It will be assumed here that a finitevector exists: autoregressive representation
Axt
=

A1Axt-1

+ ApAxt p + Y8&Xt-1+ ut

(5)

where ut is the vectorof whitenoise disturbances, and A1... Ap are matricesof autoregressive paof on differences x. rameters the lags of the first is The errorcorrectionrepresentation not the of model onlypossibleparameterization a dynamic
8 See equation (3.4) of Grangerand Engle (1987).

withco-integrated variables,but it has the advantage thatall of the variablesin the representation (dependentand independent) I(O). This means are that standard asymptotic theorycan be used to conduct statisticalinference. Granger and Engle (p. 259) note that " vector autoregressions estimatedwithco-integrated data will be misspecified if the data are differenced, will have omitted and important if constraints thedata are used in levels. Of course, these constraintswill be satisfied asymptotically efficiency but gains and improved multistep forecasts may be achieved by imposing them." An initialestimate was made witha model that included all nine variables and the six a priori errorcorrectionterms.The 8 parametersin (4) and (5) above come fromthe previoussectionof the paper, and are not estimatedsimultaneously with the otherparameters (5). The estimation of procedure followed here is therefore similar to the two-step proceduredescribedby Grangerand Engle. The system was initially estimated withsix lags of each variableincludedin each equation,as well as a timetrendand a constant.9'10 The model was judged to be unsatisfactory on the basis of Grangercausality tests that showed significant causality runningfrom Canadian to U.S. variables. U.S. interestrates were Granger rates and money at caused by Canadian interest the 1% level. U.S. outputwas Grangercaused by Canadian moneyat the 1% level.These counterinVECM and VAR models also included 9All of theestimated seasonal dummy variables, since thedata used wereunadjusted forseasonal variation. 10A completeset of statistics is fromtheseregressions available on request.

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TABLE 3.-SUMMARY STATISTICS: TWELVE LAG MODEL

This table reports various summary statistics for the VECM model estimated using a maximumlag lengthof twelve.Ssr gives the sum of squared residuals,Q reports level of for the Box-Pierceq statistic serialcorrelation up to order12, withthesignificance on listed immediatelybelow, and EC(i) gives the estimatedcoefficient the ith error in termwiththe absolutevalue of the t-statistics parentheses. correction Equation:
R2 m* i*
y* p*

R2 Ssr Q EC(1) EC(2) EC(3) EC(4) EC(5) EC(6)

0.94 0.85 0.001 11.4 0.492 0.10 (0.30) -0.00 (1.7) 0.009 (0.16) 0.114 (3.2) 0.107 (0.62) -0.07 (0.76)

0.78 0.42 35.3 15.7 0.206 -6.15 (0.73) -0.35 (2.4) -7.41 (0.56) 13.7 (1.6) 25.8 (0.60) -2.45 (0.11)

0.95 0.86 0.002 7.44 0.827 -0.19 (3.5) -0.00 (1.1) -0.08 (0.88) -0.04 (0.69) 0.150 (0.54) 0.016 (0.11)

0.83 0.55 0.000 5.79 0.926 -0.00 (0.17) 0.000 (0.12) 0.030 (1.4) -0.00 (0.04) -0.05 (0.67) -0.01 (0.23)

0.85 0.93 0.59 0.81 0.002 13.2 10.9 18.5 0.540 0.103 2.86 -0.14 (0.53) (2.2) -0.00 -0.27 (2.9) (2.0) 7.28 -0.20 (2.0) (0.86) 15.3 -0.04 (2.7) (0.59) 0.187 67.3 (2.5) (0.58) 0.196 -31.7 (2.2) (1.1)
p-i). (i--i),

0.84 0.98 0.57 0.94 0.000 0.005 5.83 12.2 0.924 0.426 0.012 -0.22 (0.93) (2.2) -0.00 -0.00 (1.3) (0.59) 0.29 -0.05 (2.2) (0.19) 0.025 -0.07 (1.8) (0.73) 0.019 -0.54 (0.27) (1.1) 0.059 0.117 (1.6) (0.44)
-y*

0.71 0.22 0.002 11.1 0.518 -0.02 (0.36) -0.00 (0.35) 0.014 (0.16) -0.07 (1.2) 0.641 (2.2) -0.28 (1.8)

Note: The six error correction terms are respectively: (y + 0.0136i* + p* - nz*), (v - v*). (y - y* + e).

(i

+ e - p* + p), (v-

TABLE 4.-GRANGER

CAUSALITY

TESTS: TWELVE LAG MODEL

Marginal significancelevels for Granger causality tests for the model with twelve lags are reportedhere. Causation from: To: i* Y* P* m i y p e
m*

m*

i*

y*

p*

i 0.231 0.082 0.800 0.956 0.286 0.797 0.472 0.607

0.224 0.969 0.574 0.021 0.218 0.966 0.000 0.670

0.062 0.793 0.169 0.403 0.016 0.885 0.787 0.370

0.888 0.376 0.052 0.850 0.011 0.946 0.038 0.337

0.418 0.118 0.814 0.539 0.067 0.973 0.362 0.064

0.157 0.114 0.888 0.859 0.000 0.411 0.447 0.040

0.931 0.573 0.242 0.192 0.838 0.033 0.265 0.613

0.433 0.384 0.887 0.602 0.052 0.356 0.893 0.732

0.520 0.085 0.800 0.937 0.355 0.230 0.955 0.110

-

variwithan omitted tuitiveresultsare consistent ables problem. It is possible that longerlags of U.S. variables cause both Canadian variablesand theselongerlags leads to U.S. variables.Omitting the Canadian variables picking up their effects and appearingto cause U.S. variables. In order to correctthese problems,a VECM systemwith a lag lengthof 12 monthswas estifromtheseregressions mated. Summarystatistics

in are reported table 3. In all equationsexceptthe equation forU.S. prices,at least one of the error at is terms significant the 5% level." In correction addition, all of the error correctionterms are in significant at least one equation. The resultsof Grangercausality tests for this model are reportedin table 4. The testswere of
11Since all variablesin theregressions I(O), conventional are applies. theory distribution

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the null hypothesis thatall lags of the first differ- This conclusionshouldbe regarded tentative. as ence of the relevantvariable could be omitted Evidence in favor of the importanceof money fromtheequation,and tookno accountof thefact comes from statistical the significance thevelocof that the level of the variablecould be includedas ity errorcorrection termin the VECM equation a componentof one or more of the errorcorrec- for industrialoutput. The ambiguity the ecoof tion terms.There are no cases of Grangercausal- nomic interpretation co-integrating of vectorshas ity from Canadian to U.S. variables at the 5% already been noted above. In addition, extreme level. Canadian industrial productionis Granger caution should be exercisedbeforetrying make to caused by no othervariable.None of theexclusion inferences about the true structure the Canaof restrictions blocks of lagged variables is re- dian economy based on the evidence presented on jected at conventional significance levels, so it here.The evidencemaybe compatible withseveral would seem at first glance thatmonetary variables different types of economic structure.'5 An atdo not have predictive contentforCanadian out- temptto use the data to discriminate amongcomapproachesto thebusiness put.12 However, the Canadian velocityerrorcor- petingmacroeconomic rectiontermis highlysignificant the Canadian cycle would necessitatethe impositionof more a in industrial productionequation. priorirestrictions the data, along the lines of on This resultmeans that increasesin the money Mishkin(1983). This is reserved future for work. stock relative to nominal income raise spending and output in the shortrun. The stationarity of DATA APPENDIX Canadian velocity has the interpretation that All series used in the study are seasonally unadjusted moneyaffects only theprice level in the long run. monthly observationstaken fromthe Main EconomicIndicaBecause the velocitytermis insignificant the torsof the O.E.C.D. The HistoricalStatistics,1964-1983 volin issues. The basic data Canadian interestrate and exchange rate equa- ume was updatedusingvariousmonthly set contains observationsfrom1964:1 to 1987:3. Data were tions,the effect appears to pass directly spend- differenced laggedbeforesubsampleselectionso thatthere to and ing ratherthan via interest rates or the exchange are no missing observations the1970:7 to 1987:3 subsample. in
rate.13" 14

All equations are therefore estimatedwith 201 observations. Variables are definedas follows: m= y= p = i= e= log of narrowly defined money(MI), end of period log of index of industrial production log of consumerpriceindex end of period Treasury bill rate,percent log of end of period spot exchangerate,(US$/Cdn$) x 100.

V. Conclusions The results of the causalitytests indicate that money mattersin Canada. Canadian velocityhas statistically significantpredictive content for Canadian industrialoutput,even thoughlags of money supply changes and interest rate changes fail to Granger-cause industrial outputat conventional significance levels.
12Ambler and Phaneuf(1988) show that Grangercausality

In the text,asterisks used to denote U.S. variables. are

REFERENCES Ambler,Steven,and Louis Phaneuf,"Interest Rate Innovafromeithermoneyor interest ratesto outputis consistent with tions and the Business Cycle," EconomicsLetters26 the importanceof monetary policy for economic fluctuations (1988), 305-309. when the central bank can use interest rates as its principal Backus, David, "The Canadian-U.S. Exchange Rate: Eviinstrument. dence froma Vector Autoregression," this REVIEW 68 13 The author is grateful one of the referees to forthe main (Nov. 1986), 628-637. elementsof thisinterpretation. Christiano,Lawrence, and Lars Ljungqvist, "Money Does 14 To investigate the sensitivity the causalityteststo deof Granger-CauseOutput in the BivariateMoney-Output trending,a VAR system was estimated in levels. Higher Relation," Journal of MonetaryEconomics 22 (Sept. adjusted R-squaredstatistics, evidenceof causalityfrom Cana1988), 217-235. dian to U.S. variables,and severalinstancesof Granger causal- Dickey,David, and Wayne Fuller,"Likelihood Ratio Statistics itywhichwere absent from VECM specification pointed the all for Autoregressive Time Series with a Unit Root," towards a potential spurious regressionproblem (Canadian Econometrica (July1981), 1057-1072. 49 output was again not Grangercaused by othervariables).The results increased our confidencethat the more satisfactory 15 specification involvesdifferencing seriesand includingthe the In a relatedcontext, Mankiw(1986) demonstrates thatthe vectors.This is compatiblewith the resultsof absence of Grangercausalityfrommoneysupply changes to co-integrating Christianoand Ljungqvist(1988) thata model estimated using incomeis compatible witha structural modelin whichnominal only the differences variablesis misspecified. of contractual rigidities important. are

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