A note on generality of the Cagan model for money demand

Abstract

The generality of the Cagan model for money demand is questioned. Some high inflationary economies are hit by external shocks that may have a non-transitory effect on macroeconomic variables including consumer prices, high-powered money, or narrow money which are usually used in these studies. When a structural break exists, standard unit-root tests such as the augmented Dickey-Fuller test or Phillips-Perron test are biased in favour of accepting the hypothesis of non-stationarity. An alternative Perron's testing procedure, which includes dummy variables that recognize the possibility of exogenous changes in level or trend, was applied on high inflation plagued Yugoslavia and Mexico. Consumer price and money variables are in both cases stationary around a deterministic breaking trend function. Therefore, no cointegration between the variables exists and the Cagan model cannot explain the nature of inflationary processes in these countries. Alternative specifications are necessary.