Does digital finance change the stability of money demand function? Evidence from China

Abstract

Understanding the stability of the money demand function is crucial for determining how money impacts inflation and output, and optimizing monetary policy operations. Our study, using China as a case study, examines the potential effects of digital finance on this stability through cointegration technology. We found that digital finance influences the stability of money demand functions differently across monetary aggregates: it leaves M0 unaltered, doesn't influence the unstable M1, but does disrupt the formerly stable M2. We further investigate how two key services of digital finance - payment and asset management - affect the stability of M0, M1, and M2 demand functions. For payment services, our findings suggest the stability impact on the money demand function follows the order of M0 > M1 > M2. In contrast, for asset management services, the impact is ranked inversely. Consistent with recent studies, our data indicates that employing the Divisia index softens the impact of digital finance on the stability of money demand functions. Moreover, it's essential to monitor the pace of reform and understand how the behaviors of unique economic entities impact the money demand function, while concurrently promoting a deeper reform of interest rate liberalization.