Cointegration and a test of the quantity theory of money
Yash P. Mehra
The main implication of the Quantity Theory of Money is that long-run movements in the price level are determined primarily by long-run movements in the excess of money over real output. This implication is related to the concept of cointegration discussed in Granger (1986), which states cointegrated multiple time series share common long-run movements. It is shown that the general price level is cointegrated with money, real output, and the nominal rate of interest. These economic variables enter a price equation based on the Equation of Exchange. Furthermore, the appearance of this cointegration in the data seems consistent with the presence of Granger-causality from money and real output to the price level. It is also shown that an inflation equation that incorporates the above stated implication of the Quantity Theory of Money predicts quite well the actual behavior of inflation during the past decade or so. These results however hold for M2, not M1, measure of money.
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