The N.A.F.T.A. Evidence on Testing the Kumara Swamy Theorem of Inflationary Gap

Abstract

This paper empirically tests the Kumara Swamy Theorem of the Inflationary Gap for the U.S.A, Canada and Mexico, the three countries that constitute the North American Free Trade Agreement (NAFTA), over the period 1997-2011. The study obtained data from the World Bank’s World Development Indicators database for each country’s Money Supply, Gross National Income and Consumer Price Index, as well as Statistics Canada’s CANSIM database. Results were compared to the seminal works of Swamy (1982 and 2009) that tested the Theorem for the Nigerian economy, as well as recent studies by Lazaridis and Livanis (2010) for the Cypriot and Greek economies, and Bauer and Faseruk (2012) for the Canadian economy. For the U.S.A., Canada and Mexico, the Kumara Swamy Theorem of the Inflationary Gap has provided notable explanatory power for the relationship between the growth of the money supply and real G.N.P. The American economy displayed the lowest inflationary gap and the Mexican economy the highest with the Canadian economy in between, but more in line with the American experience. This paper argues that the Theorem is best understood as a long-term average and to disregard short-term fluctuations. Graphical evidence demonstrates that short-term fluctuations in the inflationary gap, either positive or negative, revert to the mean in subsequent years, although the speed of adjustment varies from country to country.

Keywords: Inflationary gap, N.A.F.T.A., Kumara Swamy Theorem

JEL Classification: C82, E31, E52, E58