Is There a Causal Relationship between Money Supply and the Inflation Rate? Thoughts from the Gambia

Abstract

This study examines the causal relationship between money supply (M2) and inflation rate in The Gambia, using the Standardized Vector Error Correction Model for the period 1985 and 2018. The independent variable used in this research is inflation rate and the dependent variables are money supply (M2), official exchange rate, and gross domestic product (GDP). The results indicate that inflation in the Gambia is caused by money supply – the only variable that affects the rate of inflation in our model. On the other hand, official exchange rate and gross domestic product were found to have no significant effect on the inflation rate in the Gambia. These findings are consistent with the Quantity Theory of Money, which contends that the general price level of goods and services is proportional to the money supply in an economy. The findings of the paper do however have policy implications, particularly for the Gambia and other developing countries. At the policy level, the Central Bank of the Gambia needs to see to it that the amount of money supply is proportional to the quantity of money demanded, if the persistent increase in the country's inflation rate is to be adequately addressed.