KINGSTON UNIVERSITY, LONDONSCHOOL OF ECONOMICS

Money, Banking, and International Financein Developing Countries (FE3178), 2009-2010

Money demand

Introduction

Money demand functions are fundamental in theoretical

and empirical macro-monetary models.

In this regard, Goldfeld and Sichel (1990, page 300)

state that “…the demand for money is a critical

component in the formulation of monetary policy and a

stable money demand function for money has long been

perceived as a prerequisite for the use of monetary

aggregates in the conduct of policy.”

** Money demand’s role is particularly important in

developing economies.

That is the case because in those countries monetary

policymaking generally rests on a monetary programme

within which money demand plays a critical role.

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That contrasts to what occurs in more advanced

economies, like the United States and the United

Kingdom, where the interest rate is the main policy

instrument (e.g. Bernanke and Blinder, 1992).

This lecture introduces the theoretical and empirical

literatures on money demand.

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Theoretical models

Quantity theory

Money demand function is likely to depend on some

measures of transactions, wealth, and a set of variables

which capture asset yields.

The early versions of the quantity theory of money

(mainly Fisher’s, 1911, equation of exchange, and the

Cambridge approach, e.g. Pigou, 1917) emphasised the

proportionate relationship between the amount of money

in circulation, the volume of transactions, and the price

level.

The Cambridge approach was further developed by

Keynes (1930, 1936).

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Essentially, he made the transactions and

precautionary balances functions of the level of

income, and speculative balances a function of the

current rate of interest and the level of wealth.

Under Keynes’s assumptions the demand for money,

where W represents wealth, can be written as

MD = [kY + l(r) W] P

In the equation kY represents transactions and

precautionary balances, and l(r) W represents speculative

balances (l), which are a function of the interest rate.

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IMPORTANT: Keynes’s contribution by explicitly

distinguishing between the motives for holding money,

i.e. transactions, precautionary, and speculative.

Portfolio demand

Tobin (1958) argues that while utility derived by the

individual from his portfolio of assets depends positively

on the expected return from the portfolio, it also varies

inversely with the risk attached to the portfolio. In this

situation the demand for money takes the form

M D

P = ƒ (R,) W

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where W is the individual’s non-human wealth, and is

a measure of the degree of risk derived from holding

bonds.

Quantity theory and Friedman

In his ‘modern quantity theory’ Milton Friedman

(1956) draws attention away from the Keynesian motives

that encourage the holding of money.

Instead he analyses factors determining how much

money people want to hold in diverse circumstances.

Friedman’s demand for money takes the form

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M D

P = ƒ (Rb, Re, Pe, W, h)

Rb and Re are the expected rates of return on bonds and

equities (including durable goods), Pe is the expected

rate of change in the price level, W is Friedman’s wealth

concept, and h is the ratio of human to non-human

wealth.

Friedman’s analysis can be criticised by the fact that it

virtually ignores the role of money in the transactions

process, as well as the question of uncertainty.

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Specifying money demand functions

The standard theory of the demand for money has been

tested empirically by estimating the equation:

MD= ƒ (P, Y, R)

where MD is expected to be a ‘stable’ function of a small

number of key macroeconomic variables: P, the price

level; Y, which is a scale variable (income); and R, a

vector of interest rates, representing the opportunity cost

of holding money.

Price homogeneity is frequently imposed, which is a

testable restriction, on the grounds that the units of a

currency are irrelevant.

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So the equation becomes

M D

P = ƒ (Y, R)

Taking logarithms of the equation yields (hereafter small

caps represent logs of variables)

(m - p) = 1y + 2R

The equation assumes log-linearity in money, prices, and

income, and linearity in interest rates, which is a

common functional form.

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Theoretically, the income elasticity 1 is, for example,

0.5 in the Baumol (1952) and Tobin (1956) transactions

demand theory, and 1 in Friedman’s (1956) version of

the quantity theory.

2 , the interest rate elasticity, is expected to be negative.

The empirical literature on the demand for money in

developing countries frequently highlights a number of

factors.

Amongst such factors are the existence of non-monetary

transactions (an issue which pertains to the scale

variable to be included in the function), and the nature of

the interest rate or opportunity cost variable.

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The former has not being given much attention in the

literature, clearly because of the conceptual, as well as

the empirical, difficulties surrounding it. The latter is

discussed in more detail below.

But even though in these economies financial markets

tend to be underdeveloped, Agénor and Montiel

(1999) argue that sizeable and relatively sophisticated

financial markets exist in a large number of developing

countries.

They reckon that the problem is that few of these

countries systematically collect and report information

on interest rates’ behaviour and that precludes using that

type of data in empirical studies.

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Additionally, interest rates in developing countries

usually have a ceiling imposed by the central bank (see

Chapter 4 dealing with financial repression), or is the

product of an inefficient, non-competitive, financial

system.

The absence of well developed financial markets in most

developing countries means that real assets (e.g. land) are

likely to dominate an individual’s portfolio choice.

Under these circumstances the rate of inflation receives

a lot of attention as a suitable opportunity cost

measure, assuming that it reflects the rate of return on

real assets.

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Also, exchange rate and foreign interest rate variables

have been considered as opportunity cost measures in

demand for money functions.

The currency substitution literature explaining portfolio

shifts between domestic and foreign money, emphasises

the foreign exchange variable.

The capital mobility literature focuses on the foreign

interest rate variable (McKinnon, 1982). Adjusting the

equation to take account of these variables yields

(m - p)t = 1yt + 2Rt + 3et + 4pt

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In the equation 4 < 0, and 3 < 0 or > 0, depending on

whether currency substitution takes place or not.

Other specifications have also been considered. In a

small-open-economy setting, and thus reformulating the

previous equation to allow for the influence of foreign

elements on domestic money demand’s behavior, leads

to

(m−p )t=β1 y t+β2 ( R−R¿ )t+ξt

In the equation all the variables are as defined for

equation, while R¿

is a foreign interest rate.

The coefficient affecting ( R−R¿) is important for

capturing an open economy’s financial features (e.g.

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capital mobility, currency substitution, and

dollarisation).

And it actually proxies expected exchange rate

depreciation, inflationary expectations, and risk.

Empirical money demand studies

Financial innovation and money demand

The literature studying developing countries has

responded to money demand’s instability and related

predictability problems somehow associated with the so

called ‘missing money’ episode (Goldfeld, 1976).

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That expression originally arose in reference to pitfalls in

money demand modelling in advanced economies from

the 1970s onwards.

On this matter Goldfeld and Sichel (1990, page 300)

convey that “…especially for the United States but

elsewhere as well, matters have been considerably less

satisfactory since the mid-1970s…there was the episode

of the “missing money” when conventional money

demand equations systematically over predicted actual

money balances.”

Following that line of inquiry, Arrau and De Gregorio

(1993) use quarterly data in estimating money demand

functions for Chile and Mexico. They find no evidence

of cointegration when considering traditional money

demand specifications.

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However, they are able to estimate sensible money

demand functions after considering a financial

innovation variable entering their econometric modelling

in a random walk fashion.

Arrau, De Gregorio, Reinhart, and Wickham (1995)

further investigate money demand in a sample of

developing countries.

The authors’ main objective is explaining how financial

innovation actually affects the demand for money

function, and they use different variables in accounting

for financial innovation’s impact on money demand.

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The study employs quarterly time series data for ten

developing countries and applies time series econometric

modelling techniques.

The countries in the sample are: Argentina, Brazil, Chile,

India, Israel, Korea, Malaysia, Mexico, Morocco, and

Nigeria.

Arrau, De Gregorio, Reinhart, and Wickham find that

accounting for financial innovation in modelling money

demand for this sample of countries is quantitatively

relevant.

Moreover, the exercises show that financial innovation’s

role is positively associated with an economy’s average

rate of inflation.

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Also accounting for the role of financial innovation in

money demand, Pradhan and Subramanian (2003)

study India. They find that considering financial

deregulation and innovation is important for explaining

changes in the stability of the money demand function in

India.

Dynamic modelling

The money demand literature on developed countries has

had to embrace the growing sophistication of financial

markets and institutions.

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And in a developing economy the choice of opportunity

cost measure confronts the problem that there are usually

no freely varying interest rates where the data have been

collected.

Also, the empirical literature on the demand for money

offers a wide choice of specifications.

Traditionally, the emphasis has been on finding a stable

money demand relationship among a small number of

key macroeconomic variables.

However, the experience of the US during 1974-76,

1982-83 and 1985-86, expounded in Judd and Scadding

(1982) and Goldfeld and Sichel (1990), when the

money stock deviated substantially from the predictions

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of existing empirical models, has cast doubt on the

efficacy of such a goal.

As the previous section illustrates, much has been made

of financial innovation and the growing sophistication of

financial arrangements within and across countries.

For developing countries several authors opt to use

dynamic modelling.

E.g., Cuthbertson and Galindo (1999) on Mexico.

Also, Ghartey (1998) employs a dynamic modelling

strategy in estimating money demand in Ghana; Adams

(2000) studies Chile; and Nell investigates South

Africa (2003).

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Carruth and Sánchez-Fung (2000) study the

Dominican Republic. This latter investigation argues

that the Dominican Republic does not have a

sophisticated financial structure, but by taking account of

dynamic structure, and the role of the US as a recipient

of foreign capital flows, the authors determine

empirically an adequate demand for money function over

a long run of annual data from 1950 to 1996.

Money demand and dollarisation

Dollarisation is a generic term for identifying the

substitution of local currency for a hard currency like the

US dollar (e.g. Levy-Yeyati and Sturzenegger, 2003).

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Several reasons explain that phenomenon, including high

inflation and exchange rate depreciation. In that context

dollar demand may arise for transacting, speculating or

hedging against currency risk.

This section briefly introduces some contributions

attempting to improve our understanding of the link

between money demand and dollarisation.

Canto (1985) is an early study on money and

dollarisation. Using the Dominican Republic as a case

study, he argues that excessive money creation may

ultimately lead to exchange rate depreciation and to

consumers opting for holding foreign (e.g. the US dollar)

rather than domestic currency.

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Agénor and Khan (1996) analyse money demand and

foreign currency deposits in a sample of developing

economies. They focus on explaining the role of foreign

financial conditions and the exchange rate in determining

money demand.

Their findings show that these variables are important in

determining economic agents’ choice of holding

domestic money or currency deposits abroad.

Kamin and Ericsson (2003) draw attention to the

‘irreversibility in dollarization’ in Argentina, Bolivia and

Peru. Specifically, for Argentina they use a novel

measure of foreign currency holdings in analyzing

money demand.

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Kamin and Ericsson show that in Argentina reductions

in peso money demand are similar in magnitude to the

amount of dollar assets held by Argentine residents.

Oomes and Ohnsorge (2006) investigate money

demand in Russia. Importantly, they also develop a

measure of foreign currency holdings. The authors find

that support for money demand’s stability in Russia is

effectively reestablished using this more comprehensive

monetary aggregate.

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