A Note on Money and Economic Growth in the Baltic States

Authors

  • Per-Ola Maneschiöld University of Skövde

Abstract

In a neoclassical framework, it is established that the real money stock is an important input in the aggregate production function. This importance is due to that money is assumed to release capital and labour from the distribution and exchange process of goods and services allowing them to be more effectively used in the production process. Thus, the theoretical literature seems in general to be supportive of money as an input in the production function since it is argued to what extent rather than whether theory incorporates money as an input. However, the empirical literature is less clear on money as a significant input in the production process. Conclusions in the empirical literature is that the output elasticity of real money is negligible in developed economies while it is highly significant for developing economies where the experience from transition economies is neglected. This paper builds on the Solow (1957) seminal approach adopted in Startz (1984) to evaluate the role of the real money stock in the production process in the Baltic States. The results of the paper systematically reveal positive output elasticities of money in the Baltic States. However, the results are not only dependent on the choice of the monetary aggregate but also on the opportunity cost of capital where the role of money is less important with the use of market determined interest rates relative to proxy variables of the interest rate. The elasticity with use of the market determined interest rates is still more important than the general conclusion found in Startz (1984). The results are consistent with the neoclassical monetary theory and its incorporation of real money balances as an important input in the production function. Furthermore, money appears to be complementary to physical capital in line with the McKinnon-Shaw hypothesis. To promote economic growth, policy-makers should not hinder the development of the money and financial markets. To improve the growth potential in Estonia and Latvia, the development of the capital markets should continue for a more efficient use of the different production factors in the production process. The development of the capital markets will further release capital and labour from the distribution and exchange process of goods and services and allowing them to be more efficiently used in the production of goods and services. Increased financial stability will increase the credibility of the financial markets and the use of those markets in channelling financial capital in a more efficient way. Implementing price stability can enhance the growth potential as higher inflation can lead to lower demand for real money balances due to higher expected price levels as a consequence of increased uncertainty. Changes in the real money balances was proved to significantly affect the output elasticity of money and since money is most likely complementary to physical capital the outcome would be detrimental to aggregate output.

Author Biography

Per-Ola Maneschiöld, University of Skövde

Additional Files

Published

2006-12-01

Issue

Section

ECONOMICS OF ENGINEERING DECISIONS