Elasticity Of Money Demand Research Articles

On the impossibility of a stable and low GDP elasticity of money demand: the arithmetic of aggregation, replication and income growth

This paper shows the aggregate income (GDP) elasticity of money demand depends on the elasticity at the individual level and on population growth. As money regressions are usually formulated using US post-WW.II data, a low and stable aggregate income elasticity implies a negative and unstable elasticity at the individual level. Likewise positing a stable and non-unitary individual income elasticity implies wide variation in the conventional GDP elasticity over time. It has been possible to ignore these issues in empirical work due to collinearity between regressors and population, even for differenced data. Measuring money and income on a per household basis is a simple way to avoid these problems and to distinguish income from mere replication effects.

The predictive failure of the Baba, Hendry and Starr model of M1

Baba et al. (1992) restored a stable specification for M1 demand using an error-correction model which allowed for learning about new assets and incorporated a volatility term in long-term interest rates. Our study replicated their in-sample results, but found that their model completely breaks down over longer sample periods. We argue that this predictive failure could have been anticipated by sensitivity analysis. Their specification appears to have underestimated the interest rate elasticity of money demand because of the learning-adjustment mechanism. Our results also call into question their basic use of volatility in narrow money demand models.

The Demand for Money in Brunei

Based on data for the 1974–95 period this paper estimates demand for narrow money and broad money in Brunei using the error‐correction specification. Short‐run and long‐run elasticities are estimated with respect to real income, interest rate, expected price level and liquidity. Narrow money is quite responsive to changes in real income and interest rate in both the short and long terms. Broad money is income inelastic regardless of the time horizon, however, it is interest inelastic in the short run but interest elastic in the long run. Price elasticity of money demand is negligible in the short run but quite significant in the long run. Changes in the proportion of commercial bank assets placed in foreign money markets do not seem to affect demand for narrow money but their effect on the demand for broad money is both direct and significant.

Nominal Wage Rigidities and the Propagation of Monetary Disturbances

Recent research has challenged the ability of sticky price general equilibrium models to generate a contract multiplier, i.e., an effect of a monetary innovation on output that extends beyond the contract interval. We show that a simple dynamic general equilbrium model that includes Taylor-style (1980) wage and price contracts can account for a substantial contract multiplier under various assumptions about the structure of the capital market. Most interestingly, our results do not rely on a high intertemporal labor supply elasticity or elastic supply of capital: our preference specification is standard (logarithmic), and we can account for a strong contract multiplier even when the aggregate stock of capital is fixed. Finally, our analysis highlights the importance of the income elasticity of money demand in accounting for output persistence.

The Optimum Quantity of Money: Theory and Evidence

In this paper we propose a simple and general model for computing the Ramsey optimal inflation tax, which includes several models from the previous literature as special cases. We show that it cannot be claimed that the Friedman rule is always optimal (or always non--optimal) on theoretical grounds. The Friedman rule is optimal or not, depending on conditions related to the shape of various relevant functions. One contribution of this paper is to relate these conditions to {\it measurable} variables such as the interest rate or the consumption elasticity of money demand. We find that it tends to be optimal to tax money when there are economies of scale in the demand for money (the scale elasticity is smaller than one) and/or when money is required for the payment of consumption or wage taxes. We find that it tends to be optimal to tax money more heavily when the interest elasticity of money demand is small. We present empirical evidence on the parameters that determine the optimal inflation tax. Calibrating the model to a variety of empirical studies yields a optimal nominal interest rate of less than 1\%/year, although that finding is sensitive to the calibration.

Nominal Wage Rigidities and the Propagation of Monetary Disturbances

Recent research has challenged the ability of sticky price general equilibrium models to generate a contract multiplier, i.e., an effect of a monetary innovation on output that extends beyond the contract interval. We show that a simple dynamic general equilbrium model that includes "Taylor-style" (1980) wage and price contracts can account for a substantial contract multiplier under various assumptions about the structure of the capital market. Most interestingly, our results do not rely on a high intertemporal labor supply elasticity or elastic supply of capital: our preference specification is standard (logarithmic), and we can account for a strong contract multiplier even when the aggregate stock of capital is fixed. Finally, our analysis highlights the importance of the income elasticity of money demand in accounting for output persistence.

Financial innovations and the interest elasticity of money demand: Evidence from an error correction model

The difficulty of estimating a stable money demand function has been blamed on financial innovations of the past two decades. Gurley and Shaw's [1960] thesis implies that a proliferation of money-like assets resulting from financial innovations increased the interest elasticity of money demand. However, Hafer and Hein [1984] provided empirical evidence to the contrary. This paper presents the empirical results of the M2 demand for money using an error correction model for the period 1959:1–87:4 and two subperiods 1959:1–73:4 and 1974:1–87:4. The findings suggest lower interest and price elasticities for money demand in the second sample in which money substitutes proliferated.

Stabilization policy, exchange rate expectations, and international transmission

This paper analyzes the transmission effects of monetary and fiscal policy in a large country on output abroad using a two-country sticky-price monetary model with adjustment lags incorporated into the goods sectors of the countries. In addition, the paper considers alternative models of exchange rate expectations and examines their influence on the transmission process. In the case of monetary expansion in the home country, the general result for all expectations models is that the foreign country may experience either expansion or contraction. The reason is that the foreign country is exposed to two conflicting effects, a positive trade linkage effect coming from the home country and a loss of competitiveness due to the depreciation of home country's currency. Moreover, the final outcome depends critically on the sensitivity of the trade balance to the exchange rate because the lower this sensitivity, the smaller the loss of competitiveness due to the depreciation of home country's currency. In the case of fiscal expansion in the home country, the normal result for all expectations models is that output expands in the foreign country. The reason is that the foreign country experiences a positive trade linkage effect coming from the home country, and in the case of perfect foresight and regressive exchange rate expectations, the home currency normally appreciates, increasing the foreign country's competitiveness. However, if the semi-interest elasticity of money demand is sufficiently larger in the home country, it is possible for the home country's currency to depreciate, causing a loss of competitiveness in the foreign country, and the overall effect on the foreign country could be contractionary. Finally, in the case of adaptive and distributed lag expectations, fiscal expansion in the home country has no impact effect on the exchange rate, and the foreign country experiences only the positive trade linkage effect coming from the home country.

State Dependent Pricing and Dynamics of Business Cycles

The nature of price dynamics has long been thought important for the origin and duration of business cycles. To investigate this topic, we construct a dynamic stochastic general equilibrium macroeconomic model in which monopolistically competitive firms face fixed costs of changing the nominal prices of final goods. These prices are thus changed infrequently and discretely. The framework captures major features of the price dynamics stressed by the New Keynesian research program, particularly work on (s,S) pricing rules. However, by treating firms as heterogenous with respect to the size of fixed costs of price adjustment, we are able to study a wider range of issues than in the prior literature. For example, we explore how the nature of optimal price-setting depends on (i) the extent of persistence of variations in the money stock and (ii) the interest elasticity of money demand. Further, our model can be used to study a wide range of aspects of the positive and normative economics of monetary policy. We illustrate these topics by considering the consequences of changing the rate of inflation and by evaluating alternative policy rules.

Financial innovation, new assets, and the behavior of money demand

Two fundamental changes in US banking regulations have affected the behavior of money demand ( M1). The first authorized checkable deposit accounts paying explicit interest rates. The second allowed these rates to be market determined. The theoretical literature does not directly address the impact of these events, suggesting that they are primarily an empirical issue. However, the empirical literature has yet to agree on the impact of financial innovation on money demand; for example, several studies report an increase in the elasticity of money demand, several others report a decline. This paper uses a Lancaster-type choice model to analyze formally the expected impact of these two changes on the demand for money. The model derives specific conditions under which (i) the demand for money increases as new assets are introduced and (ii) the impact of either the introduction of new assets or the elimination of interest rate restrictions on the elasticity of money demand.

Liquidity Effects, Monetary Policy, and the Business Cycle

This paper presents new empirical evidence to support the hypothesis that positive money supply shocks drive short-term interest rates down. We then present a quantitative, general equilibrium model which is consistent with the hypothesis. The two key features of our model are that (i) money shocks have a heterogeneous impact on agents and (ii) ex post inflexibilities in production give rise to a very low short-run interest elasticity of money demand. Together, these imply that, in our model, a positive money supply shock generates a large drop in the interest rate comparable in magnitude to what we find in the data. In sharp contrast to sticky nominal wage models, our model implies that positive money supply shocks lead to increases in the real wage. We report evidence that this is consistent with the U.S. data. Finally, we show that our model can rationalize a version of the Real Bills Doctrine in which the monetary authority accommodates technology shocks, thereby smoothing interest rates.

Inflation variability and money demand in developing countries

This study provides international evidence regarding the effect of inflation variability on money demand in developing countries. Blejer and Khan have suggested that inflation variability has a negative effect in countries with high and erratic inflation and a positive effect in economies with low and stable inflation. The results of this paper clearly reject their hypothesis: a positive effect is found even for high inflation economies and a negative effect is found for some low inflation countries. Additional findings regarding money demand in developing countries reveal: 1) The long run income elasticity of money demand is in most cases above one; 2) inflation has a negative significant effect on money demand in most of the sample countries; and 3) the speed of adjustment of money balances to their desired level is not negligible in developing countries as argued by some authors. In half of the sample economies the average adjustment period exceeds one year.

The role for openness in the demand for money: Evidence from Barbados

This paper uses an optimizing theoretical framework for modelling openness in the demand for money function for a small, open, developing economy; in so doing, it subsumes the ad hoc specifications of three previous studies. Its findings confirm the importance of a measure of openness in the money demand specification for Barbados. More specifically, it appears that transactions associated with the traded sector of the economy exhibit greater elasticity of money demand than those associated with the nontraded sector.

Financial innovation and demand for money: some empirical evidence

Recent criticism of money growth targets has been based on the implications of spreading financial innovation, since the latter has been considered to undermine monetary policy effectiveness both by bringing about an increase in the interest elasticity of money demand and by producing instability of the money demand function. The empirical results presented in this paper – focusing on a single and specific case of financial innovation particularly suited to study the isssue at stake – falsify both hypotheses.

On the Variable Money Demand Elasticity: The Case of Taiwan

This study attempts to examine the money-demand function for Taiwan by applying the BCEA model of Savin and White (1978). Major Findings are: (1) the conventional double-log form is inappropriate for Taiwan; (2) the income elasticity of money demand rose from 1.29 in 1969. 2 to 1.74 in 1988. 3, compared to a range of 0.6 to 0.8 estimated for the U.S.; and (3) the interest elasticity of money demand varied from −0.25 ti −0.62 during the same period. The author has also found that estimated income and interest elasticities of money demand for the U.S. varied widely during 1970-1987. [310]

Financial innovation, deregulation, and the slope of the LM

In the last decade, the financial environment has been characterized by deregulation and financial innovation. Consequently, a large volume of studies has been undertaken to describe, analyze, and measure the impact of these developments on the interest elasticity of money demand and the stability of the money demand function, as well as on the effectiveness of monetary policy. Several shifts in the money demand function have been identified and the interest elasticity has been, in most cases, found to have increased. The latter has been attributed to the proliferation of money substitutes (Gurley and Shaw hypothesis) and to the fact that M 1 has been contaminated by more interest sensitive portfolio balances. However, the impact of recent developments, particularly that of deregulation, on the slope of the .LM schedule has not been clearly identified. It is shown here that the effect of deregulation on the slope of the LM schedule can be, at least in theory, isolated from that of financial innovation and that it depends on how interest is paid on M1 and on how the money demand function is specified. First, assume that the interest paid on M 1 is tied to the open market rate and that there is a log-linear demand function m = f ( r f ) p, where m is real balances, y is real income, r is the open market rate, and f is the reserve requirement ratio. The interest paid on M 1 is r ( l f ) and the net opportunity cost of holding such balances is rf. Thus, a competitive banking industry and no currency is assumed. Such payment of flexible interest on Ml will have no impact on the slope of the LM, since the interest elasticity, E, remains E (elm~dr) ( r /m) = / / . Under the semi-log Cagan specification, however, with m : y~e p~, E = ,~'f. Since in a fractional reserve requirement system f is less than 1, the elasticity is reduced and the LM becomes steeper. In the extreme case wh e r e f = 0, the LM is vertical. Now, assuming that interest on M1 is fixed or regulated by authorities, the loglinear function becomes m : f ( r i) B, where i is the fixed interest on M I. Then E =/3r/(r -i), so that the payment of i on M1 increases E and thus flattens LM. Finally, under Cagan function, and with fixed interest payments on M l, one obtains m : y~e ~ ' 0. It can be seen that E now equals fir, so that deregulation leaves the interest elasticity and the slope of the LM invariant to L Note that in each of the cases above, financial innovation may have raised //, so that the net impact of recent changes on E and on the slope of the LM depends both on deregulation and financial innovation.

Financial innovations and the interest elasticity of money demand in Canada

Using Canadian data for the period 1934-86, the paper empirically tests the Gurley-Shaw hypothesis that innovations in the financial markets raise the interest elasticity of money demand. The results provide sufficient evidence to reject the Gurley-Shaw hypothesis in Canada.

Interest Rates, the Forward Premium, and Unanticipated Money: Reply

has Of and 4d entering as both difference and divisor. This leads to an observation. As noted above, only if f > Od will the coefficient be positive. Such a positive result will, of course, be larger as of is larger relative to Od. We further note that the impact of large coefficients is considerably diminished since both Of and 'd enter into the divisor of the expression. Consequently, if the values of bd and of , respectively, are relatively close to one another, then the value of the coefficient of the term rt E(7)-negative or positive-is negligible. Numerous studies exist on the demand for money in various countries. While it is possible to use parameter estimates from these studies for comparison among countries, difficulties beset this approach. Differences in model specification, estimation techniques, and sample time-periods make parameter estimates less than completely comparable. Alternatively, parameter estimates from studies that provide uniform models, estimation techniques, and sample periods are rare. In what follows, we summarize two studies that bear upon the magnitude of kd and Of. Column (1) of Table I presents the results of a study by Arango and Nadiri [1]. Estimates for the domestic interest elasticity of money demand for the U.S., Canada, the U.K., and Germany are included. The sample period is 1960-75. Quarterly data is used. Column (2) displays the results of a recent study by Fair [4]. In addition to the above countries (excepting the U.S.) interest elasticity estimates for Japan and Switzerland are included.

A theorem regarding elasticities of the transactions demand for money

This paper considers the class of inventory-theoretic transactions demand for money models and proves the following theorem: the sum of the income elasticity of money demand plus the absolute value of the interest elasticity is equal to unity. This result is often ignored in empirical simulation studies and Bayesian estimation.

Monetary Policy Lessons of Recent Inflation and Disinflation

I will consider the monetary policy lessons of the recent inflation and disinflation. The next section of this paper is devoted to the decline of M1 velocity after 1981 and the demise of the “standard” money demand function. Some authors conclude that this evidence leaves us so uncertain about the nature of money demand that policymakers cannot rely at all on any presumed money demand regularities. In contrast, my working hypothesis is that the money demand continues to be a stable function of relatively few variables, but that the interest elasticity of money demand is substantially higher than previously thought. Events have not been kind to Keynesian monetary policy positions either. Keynesians tend to concentrate on interest rates -- especially real interest rates -- as the best guide to the effects of monetary policy on the economy. The real rate is discussed in the third section of the paper. The fourth section is devoted to an analysis of the importance of market expectations about monetary policy, with a particular focus on how market expectations were influenced by the Federal Reserve's introduction of new monetary control procedures in October 1979. The fifth section of the paper contains an evaluation of the contribution of monetary policy to the disinflation of the 1980s. In the sixth and final section, I conclude with some comments on the implications of the previous sections for the debate on monetary rules.