The Demand for Money in Mexico

Abstract

We analyse the demand for M1 and M3 and in particular the presence of a portfolio balance effect for Mexico over the period 1978–90 using quarterly data. The analysis uses economic theory and cointegration to guide the choice of appropriate independent variables. However, because of potential problems in applying the full system cointegration approach in finite samples, we rely more heavily on the general‐to‐specific and error correction methodology in a single‐equation framework. The empirical evidence indicates the existence of economically sensible demand for money equations for M1 and M3 which depend on income, an opportunity cost interest rate and a measure of the return to substitution between domestic and foreign assets. Unlike most earlier studies we find stable demand functions even when data from the ‘crisis period’ of the 1980s are included. The presence of a portfolio balance effect implies that, to interpret movements in peso monetary aggregates correctly, the authorities must take account of the impact of changes in the dollar–peso exchange rate.