Microeconometrics and measurement matters: Some results from monetary economics for Canada

Abstract

We use nonparametric and parametric demand analysis to investigate the inter-related problems of monetary aggregation, estimation of monetary asset demand functions, and currency substitution between Canada and the United States. Our application of Varian’s [Varian, H.R., 1982. The nonparametric approach to demand analysis. Econometrica 50 (1982) 107–113; Varian, H.R., 1983. Nonparametric tests of consumer behaviour. Review of Economic Studies 50 (1983) 99–110] NONPAR procedure indicates that the Bank of Canada’s monetary aggregates of M1, M1+, M1++, M2, and M3 are not optimal (in a revealed preference sense). Moreover, estimates of the Morishima elasticities of substitution, based on Gallant’s [Gallant, A.R., 1981. On the bias in flexible functional forms and an essentially unbiased form: The Fourier flexible form. Journal of Econometrics 15 (1981) 211–245] semi-nonparametric Fourier flexible functional form, show low substitutability between monetary assets, implying that simple-sum monetary aggregates are incorrect or biased. The results also provide evidence of currency substitution that is potentially relevant to the question of whether Canada should consider alternative exchange rate arrangements.