Abstract
The main purpose of this study is to ascertain the determinants of demand for money and its stability in Azerbaijan using monthly time series data spanning from January 2006 to November 2020. Johansen cointegration, vector error correction model (VECM) and Impulse Response Function were employed to investigate the relationship between real money demand (M1), and macroeconomic variables, namely income, inflation, interest rate and exchange rate. CUSUM and CUSUMSQ stability tests were applied to check whether the money demand function was stable during the observed period. The results of Johansen cointegration reveal a long-run relationship between mentioned variables. Consistent with money demand theory, the VECM results show that the demand for real money balances is positively related to income but it responds inversely to inflation, interest rate and exchange rate. Impulse Response Function confirms the result of VECM. Moreover, after incorporating the stability tests, the empirical results show that real money demand function is stable over the observed period, suggesting possible use of the narrow money aggregate as a target of monetary policy in Azerbaijan.
Highlights
Since the demand for money plays a major role in the formulation of appropriate monetary policy, determinants of demand for money and its stability remain in the sphere of thorough investigation
Where, (m-p), y, π, i and e represent real money balances, real economic activity, inflation, interest rate and exchange rate of manat to USD, respectively. This equation, in which real money balances are associated with income and interest rates, was created by adding inflation and exchange rate variable to the classical money demand function
Empirical findings reveal a positive relationship between income and money demand while inflation, interest rate and exchange rate have negative effects on demand for money in Azerbaijan
Summary
Since the demand for money plays a major role in the formulation of appropriate monetary policy, determinants of demand for money and its stability remain in the sphere of thorough investigation. The relationship between changes in money demand and other macroeconomic variables contributes to the determination of optimal quantity of money supplied in the economy. Stability of money demand means that there is a predictable and reliable relationship between monetary aggregates and macroeconomic variables included in the money demand function. When talking about a stable money demand, controlling the money supply by the central bank will be an effective monetary policy since the effects of a change in monetary values on macroeconomic variables such as output, interest rates and the overall level of prices can be predicted. In Friedman's [8] approach, various situations that may affect the demand for money, such as the ratio of human capital to physical capital, the benefit of holding money are mentioned
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