MONETARY APPROACH TO MEASURE UNDERGROUND ECONOMY

The monetary approach to measure the size of underground economy is based on the
assumption that cash is used to make all the transaction that agents want to keep hidden
from official records.

If the amount of currency used to make hidden transaction can be estimated, this amount
could then be multiplied by the income velocity of money to measure the size of
underground economy.

The monetary approach was first presented by gutman 1977 and feige 1979 and it has
evolved to use econometric tools in estimates made by tanzi (1982-1983) which are based
on cagon1958

Gutman (1977) without using any statistical procedure estimated the black economy by
computing the ratio of currency to demand deposits over the period 1937-76.

Fiege (1979) using the quantity theory of money, formulated that the total value of
transactions is given by the stock of demand deposits plus the stock of currency multiplied
by the velocity of currency. This value of transaction is then used to obtain derived GNP.

The difference between derived and actual GNP is assumed to represent underground
economy.

This technique was applied to measure the size of underground economy in the United
States, Australia, Italy, Canada, South Africa, Norway, India, and Pakistan, etc.

The work by tanzi (1980, 1982, and 1983) and all the papers based on his approach perform
econometric estimates of monetary aggregates used to recognizing that the income velocity
depends only on income and the opportunity cost of holding cash. the estimated equation of
the demand for currency is also useful to get the extra cash held by economic agents to
finance hidden transactions, without postulating that there was a time in the past when there
is no shadow economy.
It is assumed that income velocity of circulation for registered and hidden transaction are
equal and so the size of shadow economy is measured multiplying the extra cash by
econometrically obtained value of v.

THE USE OF MONETARY APPROACH IN THIS STUDY

The monetary approach is applied with three main assumption first underground economy
is generated through tax evasion. Second, currency alone is used to as a medium of
exchange in the underground economy. third velocity of illegal money is same as that of
legal money

In the estimation procedure first currency demand equation is estimated with the
justification that most of the transactions are carried out in the form of cash in the
underground economy in order to reduce chance of detection. The demand for currency is
measured by the ratio of currency in circulation (CC) TO M2 definition of money supply.

the following is the model to estimate the demand equation.

(CC / M 2)t 1 2(T / Y ) 3( BS ) 4(Yg ) 5(CC / M 2)t 1 (1)

DEFINITION OF THE ABOVE VARIABLES

CC Currency in circulation which is equal to currency issued, currency held by the State
bank of Pakistan and currency in tills of scheduled banks measured in million rupees

M2 money supply is measured as currency in circulation, banks demand deposits

scheduled bank time deposits with state bank of Pakistan measured in million
rupees.

T total taxes is measured by adding up the direct taxes that includes taxes on income
wealth tax, workers welfare tax and indirect tax that includes custom duties, federal
excise duties and sale tax, measured in million rupees.
Y gross domestic product is defined as the market value of goods and services
produced in the economy measured in million rupees.

BS banking services defined as the ratio of bank deposits to total number of bank
accounts measured in million rupees.

Yg growth rate in real per capita GDP measured in million rupees.

JUSTIFICATION OF THE VARIABLES

Justifications of the variables along with their expected Signs in the given currency demand
equation is given below.

Regarding the sign of tax variable it is hypothesized that as the level of taxation rises
people engages more in tax evading activities that are facilitated by the use of currency.
Hence the ratio of currency holding to money CC/M2 is expected to rise.

The hypothesized sign for the growth rate in per capita GDP is expected to be negative as
the fall is expected to occur in CC/M2 with the expansion of the economy through rapid
economic growth. The lagged currency money ratio(CC/M2)t-1 is included to capture the
lag effect that Shows the sluggishness of money market. The sign of lagged Money
currency money ratio is expected to be positive. Moreover improvement in banking
services lowers the demand for currency holdings, thus the sign of banking services is
expected to be negative in the currency demand equations.

After estimating the currency demand equation, the size underground economy through tax
evasion is gauged. The Procedure for estimating the size is as follows.

( IM ) CC / M 2 t CC / M 2 wt M
Illegal money

LM M 1 IM
Legal money

IV GDP / LM
Velocity of money
 UGE IM IV
Underground economy

TE UGE * T / GDP
Tax evasion

First, the values of currency ratio to each variable for each year with and without tax
variables are predicted by using preceding equation. The difference between the two is then
multiplied by the total value of M2 for the respective years in order to find out the level of
illegal level of illegal money as given in the above notations. Following tanzi (1983), the
difference between total money supply M2 and the estimated illegal money gives legal
money (LM). Dividing the gross domestic product GDP by legal money gives the income
velocity of money. Further, illegal money when multiplied with income velocity of money
gives us an estimate of underground economy. Finally the level of tax evasion is calculated
by multiplying estimates of underground with the ratio of overall taxes to GDP.