Currency demand stability in the presence of seasonality and endogenous financial innovation

Abstract

PurposeThis paper aims to examine the stability of the currency demand function for India with private consumption expenditure, tax–gross domestic product ratio and deposit rate as explanatory variables for the period 1996:1 to 2014:4. Additionally, this paper also tries to detect the presence of endogenous financial innovation in the currency demand function.Design/methodology/approachFor the theoretical foundation of the study, this paper has used a modified version of money-in-the-utility function. To examine the stability of currency demand function empirically, seasonal cointegration technique developed by HEGY (1990) and EGHL (1993) was applied. Finally, to detect the presence of endogenous financial innovation in the currency demand equation, the Gurley and Shaw (1960) hypothesis was tested by presenting the currency demand equation in a state–space form.FindingsThe empirical findings show that there is the absence of long-run cointegrationg relationship among the variables at the zero and annual frequency; however, there is evidence of a relationship among the variables at the biannual frequency. Moreover, the time-varying coefficient of deposit rate elasticity, used to test the Gurley–Shaw hypothesis, suggests that innovations in financial markets, especially improvements in the payment technology, raise the deposit-rate elasticity, beginning from 2010 onward.Practical implicationsThe empirical results of the paper suggest that there would be shrinkage of currency demand in future. From the monetary policy angle, the Reserve Bank of India needs to adapt adequately to a situation of shrinking demand for currency.Originality/valueApart from using seasonally unadjusted data to examine currency demand function for India, this study, for the first time, and to the best of the authors’ knowledge, tries to test the evidence of financial innovation in India by testing the Gurley–Shaw hypothesis. The findings of the study will have significant implication in the planning of the issue and distribution of currency in the fast-changing economic environment.