Re-investigation of the long run relationship between money growth and inflation in Iran: An application of Bounds test approach to cointegration

This paper re-investigates the long-run relationship between money growth and inflation, for the period of 1989- 2007 by using quarterly data of the Iranian economy. As standard unit root tests, such as Augmented Dickey Fuller (ADF) and Philips and Perron (PP) tests, are biased towards the null of a unit root in presence of structural breaks, we use Lee and Strazicich (2003) test to address this issue and test the null of unit roots. The result reveals that the variables under consideration are not in the same order of integration. Therefore to investigate the long-run relationship between variables under consideration, this paper applies the bounds test approach to cointegration. This method was developed by Pesaran et al. (2001) and can be applied irrespective of the order of integration of the variables. The results reveal that there is a long run relation among these variables and in the long run 1 percent increase in money growth cause to increase 72 percent in inflation rate, which means money is the most important variable that effect inflation in long run. Moreover we find that inflation was largely a monetary phenomenon, supporting quantity theory of money.