The Demand for Nominal and Real Money Balances in a Large Macroeconomic System

Abstract

Cointegration has become a popular empirical technique used to estimate the existence and stability of money demand relationships. A common approach has been to estimate a single equation system with real money balances (Ml), real income and an interest rate, although Hafer and Jansen [13], Friedman and Kuttner [10] and Stock and Watson [29] find only minimal support for this specification. Baba, Hendry and Starr [6] estimate a more complicated Ml relation by including specific opportunity cost variables and find stronger support for the Ml relation using post WWII data. There have been four reasons put forth to explain the lack of a cointegrating relation between Ml, real income and the interest rate. Stock and Watson [29] conclude that a stable money demand relation exists in data from 1900-89 but not for the post-war period alone. Their explanation is that sufficient variation exists in the longer sample to identify money demand, but excessive multicollinearity among variables during the post-war period prevents unique identification. Baba, Hendry and Starr [6] (BHS) maintain that misspecification of the Ml relation is the reason for poor results. They augment the money demand function with inflation, a measure of long term bond yield and risk, and learning curve weighted yields on newly introduced Ml and M2 assets. BHS claim their specification is able to account for the missing money period of 1975-76, the velocity decline of 1982-83 and the Ml explosion of 1985-86 while standard Ml models cannot. Friedman and Kuttner [10] offer a third reason why the simple money demand equation fails. They estimate a single equation model for several periods and conclude that a money demand vector exists over the 1960.2-79.4 period for Ml. However, when data is included