Abstract
The main purpose of this paper is to assess whether the Money Demand Function is stable in South Africa by employing the Johansen co-integration and the Vector Error Correction Model (VECM). The results indicate unstable money demand function among its determinant including real income, interest rate, stock price, and real exchange rate. More importantly, the M3 has a significant long-run relationship among its determinant except the interest rate. Furthermore, the short term dynamics show that unidirectional causality runs from determinants to the broader money except interest rate and exchange rate. This paper provides crucial evidence for policy-makers to consider the importance of the stock market activity to avoid misspecification of the money demand function. Keywords: Money demand, Johansen, VECM, Stock price. JEL Classifications: E5, E41 DOI: https://doi.org/10.32479/ijefi.9799
Highlights
Many macroeconomists acknowledged the importance of behavior of money demand function when formulating an efficient monetary policy
Unit Root Test Our aim in this paper is to investigate broader money demand function (M3) in South Africa using Johansen Maximum Likelihood (JML) co-integration test and Vector Error Correction Model (VECM)
The previous research has shown that financial reforms and changing monetary policies could affect the stability of money demand function
Summary
Many macroeconomists acknowledged the importance of behavior of money demand function when formulating an efficient monetary policy. The stability of the money demand function among its determinant including income and interest rate is a crucial component for the success of monetary intermediate targeting or direct approaches. This paper shows new evidence about the stability and relationship of the money demand function among its determinants in South Africa by including stock market activity in the function using the Johansen co-integration and Vector Error Correction Model (VECM). The literature over the past two decades indicates that financial reforms and switching between monetary policies have increased uncertainty about the stability of the money demand function (Kumar et al, 2013; Maki and Kitasaka, 2006; Nchor and Adamec, 2016). South Africa has experienced several different financial reforms and monetary regimes since the 1960s. A liquid asset ratio, cash reserve-based system, monetary targets regime, and inflation targeting were the main systems that the South Africa Reserve Bank (SARB) adopted (Table 1) (Aron and Muellbauer, 2002; 2007)
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