Inflation uncertainty and money demand

Abstract

We enter inflation uncertainty into error-correction models (EC) of US M1 and M2 money demand. We estimate the models using an instrumental variables procedure that is robust to mis-specification of inflation uncertainty. We find inflation uncertainty has a negative effect on M1 demand and a positive effect on M2 demand. Our results suggest that when confronted with increased inflation uncertainty, agents substitute away from M1 and to the interest bearing components of M2.

Notes

¹ The conventional LS estimators of the coefficient SE, however, will be inconsistent due to the generated regressor bias problem of Pagan (1984). The SE can be consistently estimated using the Newey–West estimator.

² That changes in output are insignificant in an EC model for M1 is consistent with Hoffman and Rasche (1991).