MOHAMMAD S HASAN P=0o+a,M,+ a2V,,+ Er △P,= ∑n△-,+v where the growth rates of real output, money, and income velocity are assumed to be exogenously determined at time period t and E, is an identically and independently distributed error term. Equation (2) is the cointegration regression and depicts the equilibrium relationship; Eq. ( 3)is the error correction equation and describes the process of adjustment to equilibrium, with Er-I being the equilibrium error of the previous period The application of quantity theory models of inflation to a developing semi monetized economy is a somewhat controversial issue. However, Chow (1987) and Duck(1993) provide good justifications for using such models in a devel oping country, while Chow(1987) has estimated a variant of a quantity theory model for the Chinese economy. In order to alleviate the problem of omitted variable bias, we specify a general model of inflation that subsumes the aggregate demand and supply factors, as well as monetary forces(Darrat, 1994; Gordon 1982; Huang,1995).Let P1=δ+81(L)M1+82(Lg1+63(LW1+δ4(LAP1+85(LIP4+Ep,(4) where the right-hand variables are the money stock(M), economywide excess demand pressure proxied by the output gap(g), wages(), agricultural pro- ductivity(AP), and a measure of industrial productivity (IP). The 8()s are lag polynomials in the lag operator and st is a serially independent error with zero mean. Equation (4)is s-curve inflation equation augmented by the inclusion of supply-side factors(Gordon, 1982) If inflation and the right-hand variables, such as growth of monetary aggregates are cointegrated, P is proportional to M from a statistical point of view. If the variables are cointegrated, the next test seeks to ascertain whether the coefficient of E-I in Eq. (3)or the coeficient of s-l in a similar error correction equation is negative and statistically significant so as to specify the short-run dynamics of the system. Granger(1988) has shown that finding cointegration also implies the pres- ence of Granger causality between cointegrated variables, at least in one direction Several institutional issues affect the mechanical application of the quantity eory as well as the general modeling strategy and deserve discussion. First over a long period of time, retail price growth in China was slowed or even halted by administrative price controls, usually accompanied by administrative wage controls. In the postreform period, price liberalization progressed in a piecemeal fashion and with considerable delays. Previous research has attempted to mea- sure the extent and character of true inflationary or deflationary pressure in the economy( Chen and Hou, 1986, Feltenstein and Farhadian, 1987, Feltenstein andPt 5 a0 1 a1Mt 1 a2Vt 2 a3Yt 1 «t (2) DPt 5 2g«t21 1 O i51 s di DMt2s 1 O i51 s bi DVt2s 2 O i51 s hi DYt2s 1 vt, (3) where the growth rates of real output, money, and income velocity are assumed to be exogenously determined at time period t and «t is an identically and independently distributed error term. Equation (2) is the cointegration regression and depicts the equilibrium relationship; Eq. (3) is the error correction equation and describes the process of adjustment to equilibrium, with «t21 being the equilibrium error of the previous period. The application of quantity theory models of inflation to a developing semi￾monetized economy is a somewhat controversial issue. However, Chow (1987) and Duck (1993) provide good justifications for using such models in a devel￾oping country, while Chow (1987) has estimated a variant of a quantity theory model for the Chinese economy. In order to alleviate the problem of omitted variable bias, we specify a general model of inflation that subsumes the aggregate demand and supply factors, as well as monetary forces (Darrat, 1994; Gordon, 1982; Huang, 1995). Let Pt 5 d0 1 d1~L! Mt 1 d2~L! gt 1 d3~L!Wt 1 d4~L!APt 1 d5~L!IPt 1 jt, (4) where the right-hand variables are the money stock (M), economywide excess demand pressure proxied by the output gap ( g), wages (W), agricultural pro￾ductivity (AP), and a measure of industrial productivity (IP). The d(L)s are lag polynomials in the lag operator and jt is a serially independent error with zero mean. Equation (4) is a Phillips-curve inflation equation augmented by the inclusion of supply-side factors (Gordon, 1982). If inflation and the right-hand variables, such as growth of monetary aggregates are cointegrated, P is proportional to M from a statistical point of view. If the variables are cointegrated, the next test seeks to ascertain whether the coefficient of «t21 in Eq. (3) or the coefficient of jt21 in a similar error correction equation is negative and statistically significant so as to specify the short-run dynamics of the system. Granger (1988) has shown that finding cointegration also implies the pres￾ence of Granger causality between cointegrated variables, at least in one direction. Several institutional issues affect the mechanical application of the quantity theory as well as the general modeling strategy and deserve discussion. First, over a long period of time, retail price growth in China was slowed or even halted by administrative price controls, usually accompanied by administrative wage controls. In the postreform period, price liberalization progressed in a piecemeal fashion and with considerable delays. Previous research has attempted to mea￾sure the extent and character of true inflationary or deflationary pressure in the economy (Chen and Hou, 1986; Feltenstein and Farhadian, 1987; Feltenstein and 672 MOHAMMAD S. HASAN