The Interrelationship between Money Supply, Prices and Government Expenditures and Economic Growth: A Causality Analysis for the Case of Cyprus

This paper investigates the short run as well the long run relationships between money supply,inflation, government expenditure and economic growth by employing the Error CorrectionMechanism (ECM) and Johansen co-integration test respectively for the case of Cyprus usingannual data from 1980 to 2009. Collectively, empirical results imply that public spendingpromotes economic development in Cyprus. However, deficit financing by the governmentcauses more liquidity effects but also inflationary pressure in the economy. Results show thatinflation negatively effects economic growth probably due to adverse supply shock. Moneysupply should be allowed to grow according to the real output of the economy but excess growthof money causes inflationary pressure in case of Cyprus. Therefore, this paper suggests that thegovernment should control its current expenditure that stimulates aggregate demand and tofocus more on development expenditure which stimulates aggregate supply and increases realoutput level.