Money Demand Equation Research Articles

Black Market Exchange Rate, Currency Substitution and Demand for Money

Strict control on foreign exchange and successive devaluation of domestic currency adopted by Algerian government for nearly four decades resulted in black market for foreign currencies, high inflation rates and consequently, lost of confidence in Algarian dinar as a unit of account and store of value. The aforementioned results have given rise to the phenomenon of currency substitution.The aim of this paper is to provide evidence of the existence of currency substitution in Algeria. Using time series data covering the period 1990-2021 and an autoregressive distributive lag (ARDL) model combined with CUSUM and CUSUMQ, the demand for money in Algeria is estimated. Our results point out to the existence of currency substitution when the black market exchange rate is incorporated in the money demand equation. Our findings contribute to the existing litterature on currency substitution issue. As far as policy makers are concerned, the existence of CS could hinder the effectiveness of stabilization policies and thus, means of reducing currency substitution should be devoted.

Monetary Aggregation and Speculative Real Money-Demand Equation: Theories, Evidence and Policy

Monetary Aggregation and Speculative Real Money-Demand Equation: Theories, Evidence and Policy

Monetary Aggregation and Speculative Real Money-Demand Equation: Theories, Evidence and Policy

Monetary Aggregation and Speculative Real Money-Demand Equation: Theories, Evidence and Policy

Modelling opportunity cost effects in money demand due to openness

AbstractWe apply a novel model‐based approach to constructing composite international financial indices (CIFIs) as measures of opportunity cost effects that arise due to openness in money demand models. These indices are tested on the People’s Republic of China (PRC) and Taiwan Province of China (TPC), two economies which differ substantially in size and degree of financial openness. Results show that (a) stable money demand equations can be identified if accounting for foreign opportunity costs through CIFIs, (b) the monetary policy intervention in the PRC over the global financial crisis period temporarily mitigated disequilibrating foreign shocks to money demand, (c) CIFIs capture opportunity costs due to openness more adequately than commonly used US interest rates and (d) CIFI construction provides valuable insights into the channels through which foreign financial markets affect domestic money demand.

The Impact of Financial Innovation on the Money Demand Function: An Empirical Verification in India

Traditional money demand functions are often criticized for persistent over-prediction, implausible parameter estimates, highly serially correlated errors and unstable money demand. This study argues that some of these problems may have emerged for the lack of factoring financial innovation into the money demand function. This study estimates money demand for India during the post-reform period, from 1996:Q2 to 2016:Q3. The money demand function is estimated with the linear ARDL approach to cointegration developed by Pesaran, Shin, & Smith (2001), Bounds testing approaches to the analysis of level relationships, Journal of Applied Econometrics, 16(3), 289–326, after employing various proxies for financial innovation. In conclusion, the study finds that there is a stable long-run relationship among variables, such as real money balances, and the scale and opportunity cost variables. In a nutshell, the study assesses the relative importance of financial innovation variables in the money demand equation, and finds that financial innovation plays a very significant role in the money demand specification and its stability. JEL Classification: E41, E44, E42, E52, O16, O53

Estimation of welfare costs of inflation: The case of Russia

This paper is devoted to the estimation of welfare costs of inflation, taking into account the peculiarities of the Russian economy. Theoretical approaches that are used in the literature to analyze the costs of inflation are discussed in the paper. It also provides an overview of the empirical studies of this topic. Research found in academic literature shows that the results of quantitative estimates are extremely sensitive to the choice of the functional form of the money demand equation, as well as to assumptions that are made to simplify the analysis, some of which do not fit Russian data. As a result, we have modified the standard approaches to estimating welfare costs of inflation, taking into account the monetization growth in Russia, and provide quantitative estimates of the magnitude of welfare costs of inflation. The results indicate a significant gain for economic agents in terms of real GDP with a decrease in inflation, which is regarded as a positive effect from the inflation targeting policy.

The demand for Divisia Money: Theory and evidence

A money-in-the-utility function model is extended to capture the distinct roles of noninterest-earning currency and interest-earning deposits in providing liquidity services to households. It implies the existence of a stable money demand relationship that links a Divisia monetary aggregate to consumption as a scale variable and the associated Divisia user-cost dual as an opportunity cost measure. Cointegrating money demand equations of this form appear for the Divisia M2 and MZM aggregates in quarterly United States data spanning the period from 1967:1 through 2019:1. The identification of a stable money demand function over a period that includes the financial innovations of the 1980s and continues through the recent financial crisis and Great Recession suggests that a properly measured aggregate quantity of money can play a role in the conduct of monetary policy. That role can be of greater prominence when traditional interest rate policies are constrained by the zero lower bound.

Economic policy uncertainty and demand for money in Australia

ABSTRACTThe demand for money has received a great deal of attention in the empirical literature. This literature, however, has emphasized factors such as interest rate, income, inflation rate and exchange rate as the primary determinants of money demand. Although an emerging strand of literature examines uncertainty as a potential determinant of money demand, findings have been mixed. Using a news-based Economic Policy Uncertainty (EPU) index and Australian quarterly data from 1998 to 2017, we study the impact of policy uncertainty on demand for money. Autoregressive distributed lag (ARDL) results show that the economic policy uncertainty measure has a negative short-run effect on the demand for money, suggesting the wider public hedge against future expected inflation, and positive long-run effect, whereby the broader public hold more cash to stay liquid during times of economic uncertainty. Also, introducing nonlinearity into the money demand equation, we find an asymmetric effect, more in favour of currency appreciations, supporting the expectations effect of further appreciations in exchange rate movements.

On the Stability of Euro Area Money Demand and Its Implications for Monetary Policy

AbstractWe employ a recent time‐varying cointegration test to revisit the usefulness of long‐run money demand equations for the ECB, addressing the issue of their instability by means of a model evaluation exercise. Building on the results, we make a twofold contribution. First, we propose a novel stable money demand equation relying on two crucial factors: a speculative motive, represented by domestic and foreign price‐earnings ratios, and a precautionary motive, measured by changes in unemployment. Second, we use the model to derive relevant policy implications for the ECB, since excess liquidity looks more useful for forecasting stock market busts than future inflation. Overall, this evidence points to (i) a possible evolution of the monetary pillar in the direction of pursuing financial stability and (ii) the exclusion of a sudden liquidity–driven inflationary burst after the exit from the prolonged period of unconventional monetary measures.

Currency Substitution And Stability Of Money Demand In Ghana

Monetary policymakers and economists in Ghana have become very disconcerted about the policy implications of the widespread demand for and gradual shift to the use of foreign currency in the economy in recent years. The question of whether the mounting trend of dollarization provides evidence of currency substitution has remained an empirical quest. The purpose is to empirically establish whether the data provides evidence of currency substitution. The method employed models a long-run money demand function within the portfolio balance framework, which distinguishes between capital mobility and currency substitution and also accounts for the pre and post inflation targeting monetary policy regime. The estimation technique follows the cointegration and error correction framework using the Autoregressive Distributed Lag model for annual data from 1960–2013. The variables used are real money balances (defined in both narrow and broad terms) and real income, domestic interest rates, foreign interest rates, and exchange rates. The study reports that there is a stable long-run relationship between real money balances and the determinants. The results highlight that the income elasticity for narrow money is close to one but less than unity for broad money. The coefficient of the interest rate variable is negative for narrow money but positive for broad money pointing out differences in the definition of the two categories of money. Also, whereas the coefficient for returns on foreign bonds is negative for both narrow and broad monetary aggregates, the exchange rate variable remains positive throughout. The findings reveal that, although there is no empirical evidence to support currency substitution, exchange rates and foreign interest rates are significant factors in the domestic money demand dynamics. The validity of foreign interest rate and/or the expected depreciation of the domestic currency in the long-run money demand equation capture the existence of capital mobility. The implication is that domestic agents use foreign currencies together with the domestic currency, although the domestic currency remains the legal tender for domestic transactions. The results underscore the importance of developments in foreign interest rates and exchange rates for fiscal, monetary, and exchange rate policies in Ghana. The policy implications of these findings have been deliberated to provide a guide for policy choices in the emerging economy.

Optimal inflation to reduce inequality

A popular argument in favor of price stability is that the inflation-tax burden would disproportionately fall on the poor because wealth is unevenly distributed and portfolio composition of poorer households is skewed towards a larger share of money holdings. We reconsider the issue in a DSGE model characterized by limited participation to the market for interest bearing assets (LAMP). We show that a combination of higher inflation and lower income taxes reduces inequality. When we calibrate the share of constrained agents to fit the wealth Gini index for the US, the optimal inflation rate is above 4%. This result is robust to alternative foundations of money demand equations.

Optimal Inflation to Reduce Inequality

A popular argument in favour of price stability is that the inflation-tax burden would disproportionately fall on the poor because wealth is unevenly distributed and portfolio composition of poorer households is skewed towards a larger share of money holdings. We reconsider the issue in a DSGE model characterized by limited participation to the market for interest bearing assets (LAMP). We show that a combination of higher inflation and lower income taxes reduces inequality. When we calibrate the share of constrained agents to fit the wealth Gini index for the US, the optimal inflation rate is above 4%. This result is robust to alternative foundations of money demand equations.

On the empirical relevance of the Lucas critique: the case of euro area money demand

This paper examines the relevance of the Lucas critique for euro area money demand. Based on the money in the utility function approach, a vector error correction model is specified to investigate the relationship between money and inflation in times of policy shifts. A well defined equation for money demand is obtained. The results indicate that the evolution of M3 is still in line with money demand. In the long run, inflation is affected by asset prices and detrended output. Our results show that the Lucas critique can be refuted in case of euro area money demand for the period of quantitative easing. Thus, the estimated money demand equation provides reliable information for the conduct of future monetary policy.

Economic Sanctions, Speculative Attacks and Currency Crisis

In this study, the effects of economic sanctions and speculative attacks on creating currency crisis have been investigated in Iranian economy during recent years. Economic sanctions can lead to currency crisis through trade barriers and restrictions on financial transactions and also speculative attacks can stimulate currency crises. According to the important of this issue, new model of currency crisis introduced based on Neo-Keynesian framework in Iranian economy. Also, the stock of foreign assets that held domestically is estimated using money demand equation with ratchet mirrors. Iranian holdings of US dollar assets estimated using DOLS approach. MRS-GARCH is used to capture dynamics of speculative attacks and Beta-Skew-t-EGARCH model is used to generate economic uncertainty variable using exchange rate, interest rate, inflation and economic growth variables. The results of model estimation based on CCR approach indicate that economic sanctions and speculative attacks have positive and significant effect on currency crisis.

A Tacit Monetary Policy of the Gulf Countries: Is There a Remittances Channel?

The strong economic ties between the GCC economies and the U.S. are manifested in three ways: currency peg, coupling of monetary policy, and the adoption of the U.S. dollar as the trading currency for oil. This paper examines how these dynamics result in a misalignment of the U.S. monetary policy with the business cycles of the GCC economies. The study shows how the staggering amount of remittances outflow of the GCC economies plays a stabilizing role as a tacit monetary policy tool. Incorporating remittances in the money demand equation results in a more robust model than otherwise. We further find that the effect of the Federal Funds rate on money demand in these countries diminishes in significance during the period of oil boom between 2002 and 2009. However, the transmission effect of the recession periods in the U.S. into the demand for money in the GCC countries is not statistically significant.

Financial Deregulation, Economic Uncertainty and the Stability of Money Demand in Australia

This article investigates the financial deregulation, economic uncertainty and the stability of money demand (M1 & broad money (BM)) in Australia for the periods between 1976:2 and 2008:4. We use Johansen procedure of cointegration to estimate the long‐run stationary relationship between Australian monetary aggregates and the explanatory variables. We use generalised autoregressive conditional heteroscedasticity (1, 1) model to construct an economic uncertainty index. The results suggest that there is evidence of long‐term relation between money (M1), economic activity, interest rate and price for the pre‐deregulation subperiod. However, there is no evidence of long‐run equilibrium relation between real M1 and its determinants for the baseline specification. However, the model with uncertainty index confirms a stable long‐run relationship. Moreover, we found no cointegration relation among BM, real GDP and long‐term interest rate for post‐regulation and for the entire sample for the traditional money demand equation. However, we have consistent evidence of long‐run equilibrium relation between BM, real activity and short‐term interest rates for subperiods and for the entire sample period when we account for economic uncertainty.

Reconsidering the welfare cost of inflation in the US: a nonparametric estimation of the nonlinear long-run money-demand equation using projection pursuit regressions

This paper, first, estimates the appropriate, log–log or semi-log, linear long-run money-demand relationship capturing the behavior US money demand over the period of 1980:Q1–2010:Q4, using the standard linear cointegration procedures found in the literature, and the corresponding nonparametric version of the same based on projection pursuit regression (PPR) methods. We then, compare the resulting welfare costs of inflation obtained from the linear and nonlinear money-demand cointegrating equations. We make the following observations: (i) the appropriate money-demand relationship for the period of 1980:Q1–2010:Q4 is captured by a semi-log function; (ii) based on the estimation of semi-log cointegrating equations, the welfare cost of inflation was found to at the most lie between 0.0131 % of GDP and 0.2186 % of GDP for inflation rates between 0 and 10 %, and; (iii) in comparison, the welfare cost of inflation obtained from the semi-log non-linear long-run money-demand function, derived using the PPR method, for 0–10 % of inflation ranges between 0.4930 and 1.9468 % of GDP. However, the standard errors associated with the welfare cost estimates obtained from PPR relative to the linear models tend to indicate that the nonlinear money demand provides more precise estimates of the welfare costs primarily for higher rates of inflation.

Money demand in the euro area, the US and the UK: Assessing the role of nonlinearity

This paper estimates money demand equations for the euro area, the US and the UK using a quantile regression framework and a smooth-transition regression. The quantile regression technique highlights that: (i) the income and the interest rate semi-elasticities are significantly different from the OLS estimates at the tails of the distribution of real money holdings; and (ii) the sensitivity of money demand with respect to inflation tends to be larger when real money holdings are extremely low. Finally, the smooth transition model provides two interesting findings. On the one hand, they capture reasonably well the nonlinear dynamics associated with the money demand function. On the other hand, they show that the elasticity of money demand with respect to inflation rate, interest rate, GDP and exchange rate varies not only in accordance with the regime considered, but also across the countries under consideration.

Measuring the Underground Economy with the Currency Demand Approach: A Reinterpretation of the Methodology, With an Application toItaly

We contribute to the debate on how to assess the size of the underground (or shadow) economy by proposing a reinterpretation of the traditional Currency Demand Approach (CDA)à laTanzi. In particular, we introduce three main innovations. First, we take a direct measure of the value of cash transactions—the flow of cash withdrawn from bank accounts relative to total non‐cash payments—as the dependent variable in the money demand equation. This allows us to avoid unrealistic assumptions on the velocity of money and the absence of any irregular transaction in a given year, overcoming two severe critiques to the traditionalCDA. Second, in place of the tax burden level, usually intended as the main motivation for non‐compliance, we include among the covariates two direct indicators of detected tax evasion. Finally, we control also for the role of illegal production considering crimes like drug dealing and prostitution, which—jointly with the shadow economy—contributes to the larger aggregate of the non‐observed economy and represents a significant component of total cash payments. We propose then an application of this “modifiedCDA” to a panel of 91 Italian provinces for the years 2005–08.

Money Demand Models for Russia: A Sectoral Approach

We estimate money demand models for certain monetary aggregates across different institutional sectors (a novelty for the Russian case). Our results comprise a collection of money demand equations that include different combinations of explanatory variables. Comparing the validity of these models on the basis of statistical criteria is virtually implausible. Therefore we suggest the simultaneous employment of a whole set of such models and illustrate the approach by presenting the distribution of monetary overhangs calculated on the basis of the estimated models.