Economic uncertainty, precautionary motive and the augmented form of money demand function

Abstract

A notable feature of empirical research on the inclusion of the economic uncertainty in the money demand function is that very few published papers rely on the specifications with formal clarity by studying the response of precautionary demand for money to changes in economic uncertainty. To overcome this shortcoming, this study uses the augmented form to specify the demand for money function and examines the empirical validity based on a sample of eleven countries, including four developed countries and seven developing countries. Using the panel error-correction technique, the findings provide some policy implications; the augmented form of money demand function can characterize the difference between the three primary motives of money demand—the precautionary motive, the transactions motive and the speculative motive, and support the choice of narrow money as a guide for monetary policy that ensures that economic agents have enough money to meet unexpected expenses triggered by economic uncertainty and helps to fine-tune the interest rate misalignment and output disruption that eventually improves the effectiveness of monetary policy.