Income or Wealth in Money Demand: An Application of Non-Nested Hypothesis Tests

Abstract

The purpose of this paper to apply the new econometric literature on non-nested hypothesis testing to the issue of whether income or the appropriate scale variable in money demand functions. This important for two reasons. First, as MacKinnon points out empirical work using non-nested hypotheses tests still all but non-existent [11, 106]. Hence this paper helps fill one significant void in the applied econometrics literature. Second, the issue is it income or it wealth an important one, (as explained below) but, unfortunately, an unsettled one. Early research by Chow [1], Laidler [7] and Meltzer [12] that utilized a variety of goodness-of-fit and t tests generally concluded that the appropriate variable. The results of more recent research utilizing the same methodology are mixed. For example, Goldfeld [6] and Lieberman [10] argue income the appropriate variable, while Friedman [3] argues it wealth. The view taken in this paper that even though the argument over the proper scale variable an old one, it remains an important one and deserves to be examined through the prism of new econometric methods. The issue of the relevant scale variable remains important because the money demand function plays a crucial role in both monetary and fiscal policy. On the monetary side, successful implementation of an interest rate approach to money stock control rests on the Federal Reserve's use of the correct money demand function. If the Fed employs a misspecified money demand function, it will not know the federal funds rate that consistent with its money targets and, as a result, will miss those targets. Similarly, money demand plays a crucial role in fiscal policy. If money demand does not depend on wealth, then the often cited portfolio crowding out effect that monetarists claim offsets bond-financed fiscal stimuli [4] non-existent. Hence, even bond financed government purchases are expansionary.