In this paper, the causal nexus between monetary aggregates with real economic activity (output) and liquidity aggregates with real economic activity output has been empirically examined using Granger causality test in the context of India. Using quarterly data from 1996: Q3 to 2005: Q3, it is found that there is unidirectional Granger causality from monetary aggregates to output as well as liquidity aggregates to output, except for reserve money which shows bidirectional causality. The data is used in the first difference for two alternative definitions of money supply, namely, M0 and M3 and two alternative definitions of liquidity aggregates such as L1 and L2. The result suggests that by altering either the monetary aggregates or liquidity aggregates, the monetary authority can significantly affect the output in the economy.

The effect of changes in money supply on real economic activities has been well recognized in the economic literature. The monetary authority, which formulates and implements the monetary policy, is more concerned about the behavior of money supply, i.e., the various monetary aggregates in the economy. There are certain bothering information, which monetary aggregates provide about its transmission mechanism. Substantial literature has been devoted to study the relationship of monetary aggregates with various macroeconomic variables. The stable relationship between these two provides useful information to the Central Bank to choose appropriate intermediate target of monetary policy in order to achieve the desired objectives of monetary policy.

The question that often arises is whether money causes output. It appears to be an important question for many economists working in the area of macro-monetary economics. Economists, researchers and policymakers often applied various statistical and econometric methods to investigate the empirical relationship between money and real economic activity. The popular method widely used is the Granger causality test (Granger, 1969). This approach tests whether past values of one variable help to predict the current values of the other variable. Granger causality test is widely applied in testing the causality among various economic variables. Voluminous literatures are available on the application of Granger causality tests on various aspects of economics, including money and income. Still there is paucity of studies to examine the Granger causality between liquidity aggregates and the output. This study seeks to fill the gap in the literature by systematically exploring the question of Granger causality between monetary aggregates with output and liquidity aggregates with output.

Applied Finance Journal, Monetary Aggregates, Central Bank, Monetary Policy, Economists, Econometric Methods, Statistical Methods, Indian Financial Markets, Financial Liberalization, Gross Domestic Products, GDP, Indian Economy, Time Series.