Abstract
AbstractWe apply a novel model‐based approach to constructing composite international financial indices (CIFIs) as measures of opportunity cost effects that arise due to openness in money demand models. These indices are tested on the People’s Republic of China (PRC) and Taiwan Province of China (TPC), two economies which differ substantially in size and degree of financial openness. Results show that (a) stable money demand equations can be identified if accounting for foreign opportunity costs through CIFIs, (b) the monetary policy intervention in the PRC over the global financial crisis period temporarily mitigated disequilibrating foreign shocks to money demand, (c) CIFIs capture opportunity costs due to openness more adequately than commonly used US interest rates and (d) CIFI construction provides valuable insights into the channels through which foreign financial markets affect domestic money demand.
Highlights
The lack of appropriate measures for opportunity costs in conventional money demand models is a widely acknowledged problem for empirically establishing a stable relationship between money demand and the domestic interest rate; see Calza et al (2001)
Taking the People’s Republic of China (PRC) and Taiwan Province of China (TPC), two export-oriented economies which differ substantially in size and degree of financial openness, as case studies, this paper develops composite international financial indices (CIFIs) as measures of opportunity costs in conventional money demand equations to test whether stability can be maintained by inclusion of such measures
We evaluate the CIFI-augmented model (5) against the closed economy baseline (3) and a version of (4) in which we adopt the prominent use of US interest rates RtUS as a proxy for foreign opportunity costs in the literature
Summary
The lack of appropriate measures for opportunity costs in conventional money demand models is a widely acknowledged problem for empirically establishing a stable relationship between money demand and the domestic interest rate; see Calza et al (2001). Emerging market economies that have deepened their financial sectors and heightened financial integration over recent decades are vulnerable to instability in the money demand equation. This is because the increased availability of assets potentially alters the sensitivity of money holdings to domestic interest rates, undermining the interest rate as an effective policy tool; see Gurley and Shaw (1955), Poole (1970) and Darrat and Webb (1986). Taking the People’s Republic of China (PRC) and Taiwan Province of China (TPC), two export-oriented economies which differ substantially in size and degree of financial openness, as case studies, this paper develops composite international financial indices (CIFIs) as measures of opportunity costs in conventional money demand equations to test whether stability can be maintained by inclusion of such measures
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