Expected income in the demand for money: An ‘unobservable variable’ analysis

Abstract

A demand for money function is specified with unobservable expected (or permanent) income as one of the explanatory variables. The model is formulated within the latent or unobservable framework and considers two cases. First, where there is a simple ‘measurement error’ relationship between latent and actual magnitudes, and second where expected income is assumed generated by a more dynamic mechanism. In both cases a consumption function with permanent income as an explanatory variable is incorporated into the model to supply the information necessary to identify the structural parameters. Identification of the models is discussed and a suitable estimation procedure developed and applied to time series data for the United Kingdom.