Abstract
This paper derives the monetarist version of broad money demand function for Sri Lankan economy using the quarterly data for the period from 1988: Q1 to 2012: Q4. This study employs both Johansen and Juselius (1990) multivariate method and Granger’s (1987) two-step method for cointegration to obtain structural values of the long-run money demand function: The stability of the model is tested using recursive coefficients and cumulative sum of squared residuals (CUSUM) tests. Results obtained from both co-integration testes suggest that the income elasticity of broad money demand is equal to one. Hence, it would provide an important guidance for the monetary authorities to regulate money supply as the intermediate target in order to achieve the final goal/goals of economic and price stability via the monetary transmission mechanism. This study concludes that growth of money over and above the real GDP growth will result inflation. The structural estimate received for inflation is higher than that of the real Treasury bill rate. Both the estimates are in theoretically expected signs and are also statistically significant. It means that public in Sri Lanka tend to substitute money for more real assets than the alternative financial assets during the time of higher inflation. Our tests on the stability of the broad money demand function confirmed that it is stable over time.
Highlights
Clear understanding about the characteristics of the money market, including the money demand function is essential for effectiveness of monetary policy in a country
If the calculated Augmented Dickey Fuller (ADF) value is less than the ADF critical value in absolute terms at 5% significant level in general, the null hypothesis (Ho) is not rejected and the series concerned does have a unit root or vice versa
This paper examined the validity of the monetarist version of money demand function for Sri Lanka using Johansen and Juselius (1990) Multivariate and Engle and Granger (1987) two-step methods for co-integration
Summary
Clear understanding about the characteristics of the money market, including the money demand function is essential for effectiveness of monetary policy in a country. An optimal monetary policy is hard to be formulated without identifying stable estimates of money demand relation, and other relationships connected to money demand. In Sri Lanka, the monetary policy framework, has not been focused on collecting information on the money demand function. The income and interest rate elasticities of money demand are predominant in most the basic macroeconomic models such as the IS-LM model where the effectiveness of monetary policy depends on the elasticity of money demand. A stable money demand function is a prerequisite to conduct an effective monetary policy in an economy where the monetary aggregate is the target variable. It helps the policy makers to identify the proper and efficient policy instruments to achieve the final economic goals through appropriate intermediate targets
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