How stable is the demand for money in emerging economies?

Abstract

One of the key elements of implementing the monetary policy is stability of the demand for money. The literature includes a large number of studies that have tested the stability of the money demand in developed as well as less-developed countries but not in emerging economies of Eastern Europe. As market-based data becomes available from these countries, there is an urgency to test old theories for these modern market-oriented economies. In this article we consider the experiences of Armenia, Bulgaria, the Czech Republic, Hungary, Poland, Russia and the Slovak Republic. Using the bounds testing approach to error-correction modelling and cointegration, we show that money demand is stable in these countries.

Notes

¹ Mehra (1997), Sriram (2001) and Calza and Joao (2003) provide a review of empirical money demand studies.

² For US studies, see Hafer and Jansen (1991) and Ball (2001). Filosa (1995), Hayo (2000), Funke (2001), Hondroyiannis and Swamy (2001), Kontolemis (2002) and Roffia et al. (2006) examine the stability of money demand in several European countries.

³ Arrau et al. (1991), Khan and Agenor (1996), Sriram (1999) and Hafer and Kutan (2003) provide evidence from developing countries.

⁴ Brada and Kutan (1997, 2000), Nenovsky and Hristov (2002) and Égert and Kutan (2005) summarize the experience of many countries.

⁵ For a recent discussion on exchange rates and inflation targeting regimes in Eastern European countries, see Orlowski (2001), Siklos and Ábel (2002), Jones and Kutan (2004), Kutan and Orlowski (2006) and Orlowski and Rybinski (2006).

⁶ This section closely follows Bahmani (2008).

⁷ Competing theories provide different theoretically expected estimate for b. For example, while square-root law predicts a 0.5 estimate for b, monetarists favour a value of one. Based on this estimate, monetarists would argue for central banks to allow the money supply to grow at the same growth rate of GDP so that it can keep up with the increase in the demand for money.

⁸ For more on the expected sign of d, see Arango and Nadiri (1981) and Bahmani-Oskooee and Pourheydarian (1990).

⁹ For more on this point, see Laidler (1993, p. 175).

¹⁰ Note that by relying on the money demand function outlined by Equation 1 as the relationship between money, income, inflation rate, and the exchange rate, we are assuming that the identifying Assumption 3 outlined by Pesaran et al. (2001, p. 293) holds. Of course, this assumption could directly be tested for the exclusion of the lagged money variable (ln M_{t −1}) in (2). However, since asymptotic properties of such test is not available, we follow Pesaran et al. (2001) and assume that their Assumption 3 holds.

¹¹ Note that EC _{t −1} is formed using the long-run coefficient estimates. After replacing the lagged level variables in (2) by EC _{t −1} and after imposing the optimum lags, (2) is estimated one more time.

¹² Note that as recognized by Pesaran et al. (2001, p. 314) and others in the literature, despite their low powers, the CUSUM and CUSUMSQ tests are the most commonly used tests with error-correction modelling framework to establish stability of short-run as well as long-run coefficients. Such tests have been applied by Buch (2001), Payne (2003), Bhaskara and Singh (2006) and Narayan and Smyth (2006) in this journal. For some other issues in money demand literature, see Chowdhury (1997), Tan (1997), Knell and Stix (2006) and Hu and Wua (2007).