How justified is abandoning money in the conduct of monetary policy in Australia on the grounds of instability in the money‐demand function?

The role of money in the design and conduct of monetary policy has reemerged as an important issue in both advanced and developing economies, especially since the 2007 global financial crisis. A growing body of recent literature suggests that the causal relationship between money supply growth and inflation remains intact across countries and over time and that this relation is not conditional on the stability of the money‐demand function or whether money is endogenous or exogenous. Moreover, critical for a rule‐based monetary policy is the presence of a long‐run stable money‐demand function, rather than a short‐run money‐demand model that may exhibit instability for many reasons, including problems with estimating a money‐demand model with high‐frequency data. Provided that a stable money‐demand function exists, it could be useful to establish long‐run equilibrium relations among money, output, prices, and exchange rates, as the classical monetary theory suggests. Within this analytical framework, this paper addresses the question of whether money has any role in the conduct of monetary policy in Australia. The conventional wisdom is that the money‐demand function in Australia has been unstable since the mid‐1980s due to financial deregulation and reforms; this led to a change in the strategy of monetary policy for price stability in the form of inflation targeting that ignores money insofar as inflation and its control are concerned. This paper reports empirical findings for Australia, obtained from a longer quarterly data series over the period 1960Q1–2015Q1, which suggest that instability in the narrow‐money‐demand function in Australia was primarily due to the exclusion of variables which have become important in the deregulated environment since the 1980s. These findings are confirmed by an expanded form of the narrow‐money‐demand function that was found stable over the past two decades, although it experienced multiple structural breaks over the study period. The paper draws the conclusion that abandoning the monetary aggregate as an instrument of monetary policy in Australia, under a rule‐based monetary policy such as inflation targeting, cannot be justified by instability in the money‐demand function or even by lack of a causal link between money supply growth and inflation.     

Monetary policy arithmetic: reconciling theory with evidence

Abstract.  Empirical evidence indicates that, in countries with low inflation rates, a permanent decrease in inflation rate either has no impact on capital stock and output (superneutrality) or causes them to fall moderately. Existing budget arithmetic models of monetary policy cannot deliver superneutrality. In this paper, we conduct a budget arithmetic analysis of monetary policy using a money demand specification – money in the utility function – that is new to this literature. We find that one simple assumption about utility from money delivers superneutrality, while a more general assumption delivers departures from superneutrality in the direction consistent with the evidence. JEL classification: E60, E13     

Monetary policy with an overrestricted demand for money equation: Chile in the 60's

The purpose of this paper is to show that in designing monetary policy special care should be taken in the specification of the demand for money equation. An evaluation of the a priori restrictions imposed by Chilean monetary authorities on the demand for money equation during 1965–1969 demonstrates that monetary policy, rather than passively accomodating the supply of money to the demand for money as was the intention of the Central Bank, instead actively restricted the supply of money below the quantity demanded.     

Long-Run Elasticities of the Demand for Money in Korea:Evidence from Cointegration Analysis

Most recent studies have employed the cointegration technique to investigate the long-run stability of the demand for money. This study considers the case of Korea. It is shown that in the long-run while Ml monetary aggregate is cointegrated with income, interest rate, and the exchange rate, M2 is not. However, results from error correction models reveal that both Ml and M2 have short-run relationship with their determinants. [E41]     

On the empirical specification of the European demand for money

This paper tests several aspects concerning the specification of an empirical demand for money function for the European Monetary Union. The econometric results show that wealth is a statistically significant determinant for the demand for money. A homogeneous sample period is statistically established, and a demand equation for liquid assets (other than strict money) is presented. A new method to weight and add national variables is also suggested to obtain European aggregates. The main policy implication is that monetary aggregate targeting should not be the main basis for monetary policy implementation.     

Re‐vitalizing money demand in the Euro area. Still valid at the zero‐lower bound

The analysis of monetary developments has always been a cornerstone of the ECB's monetary analysis and, thus, of its overall monetary policy strategy. In this respect, money demand models provide a framework for explaining monetary developments and assessing price stability over the medium term. It is a well‐documented fact in the literature that, when interest rates are at the zero‐lower bound, the analysis of money stocks become even more important for monetary policy. Therefore, this paper re‐investigates the stability properties of M3 demand in the euro area in the light of the recent economic crisis. A cointegration analysis is performed over the sample period 1983 Q1 and 2015 Q1 and leads to a well‐identified model comprising real money balances, income, the long‐term interest rate and the own rate of M3 holdings. The specification appears to be robust against the Lucas critique of a policy dependent parameter regime, in the sense that no signs of breaks can be found when interest rates reach the zero‐lower bound. Furthermore, deviations of M3 from its equilibrium level do not point to substantial inflation pressure at the end of the sample. Excess liquidity models turn out to outperform the autoregressive benchmark, as they deliver more accurate CPI inflation forecasts, especially at the longer horizons. The inclusion of unconventional monetary policy measures does not contradict these findings.     

WEALTH,ASSET PORTFOLIO,MONEY DEMAND AND POLICY RULE

I look at the linkages between monetary policy and asset wealth using quarterly data for the USA. I show that a positive interest rate shock leads to a fall in aggregate wealth and an important change in portfolio composition: housing wealth gradually decreases, but the effects are very persistent; and financial wealth quickly shrinks, but the impact is short‐lived. I also find that the money market can be characterized as follows: (i) the money demand has a large interest elasticity and a small output elasticity; and (ii) the estimated monetary policy reaction function highlights the special focus given by the central bank to developments in monetary aggregates. These features call for an approach whereby monetary authorities put more emphasis on tracking wealth developments, in particular, given the asset portfolio rebalancing between money holdings and financial and/or housing assets.     

Monetary transmission in Spain: a structural cointegrated VAR approach

This paper analyses the monetary policy channels in Spain using a cointegrated structural VAR approach which explicitly accounts for endogenous policy reactions in a small open economy. Evidence is found of one cointegrating relation which is identified as a long-run money demand function. In addition, stability tests are applied to this relationship to assess whether there has been a change of monetary regime. The impulse-responses for the non-monetary shocks as well as the absence of the puzzles traditionally found in the empirical literature, suggest that the model specification identifies the monetary policy shocks correctly. Thus, according to our results, a monetary contraction causes a weak downward response in the price level, as well as an increase in both short and long-run nominal interest rates, a decrease in aggregate output and an exchange rate appreciation.     

The Monetary Analysis of Hyperinflation and the Appropriate Specification of the Demand for Money

Abstract. This paper emerges from the failure of the traditional models of hyperinflation with perfect foresight. Insights from two standard optimizing monetary settings and economic reasoning from case studies of extreme hyperinflation episodes provide relevant requirements for the specification of the demand for money during hyperinflation. The paper demonstrates that the possibility of perfect foresight monetary hyperinflation paths depends robustly on the essentiality of money. The essentiality of money provides some depth of explanation of the reasons why the popular semi‐log schedule of the demand for money is not appropriate for analysing monetary hyperinflation with perfect foresight. The paper proposes a simple test of money essentiality for the appropriate specification of the demand‐for‐money equation in empirical studies of hyperinflation.     

The role of capital flows in the adjustment of money demand: The case of Finland

The paper models the dual role of money balances as a short-run buffer stock and an asset with a well-specified long-run demand function. The analysis is carried out in an open economy framework. Consequently, there will be an offset to monetary policy in the form of induced capital movements, but in our model, it will be distributed over time even under perfect substitutability of financial claims. Estimates for the parameters of the demand for money function are obtained from a capital flow equation using both unrestricted (OLS) and restricted (nonlinear) estimation methods. The results provide strong evidence in favour of the shock-absorption theory for the adjustment of money demand under money supply changes.     

Asymmetric responses of money demand to oil price shocks in Saudi Arabia: a non-linear ARDL approach

Saudi Arabia is an open oil-based economy with fixed exchange rates; therefore, it has limited monetary policy autonomy. Using non-linear autoregressive distributed lag approach, this article investigates the asymmetric effects of oil price shocks on the demand of money in Saudi Arabia over the period 1990:Q1–2014:Q4. The empirical results show evidence of positive long run but asymmetric effects of oil price shocks on the money demand. In particular, we find that the positive oil price shocks are more important than negative shocks. Therefore, two policy responses can be considered: either sustaining the fixed exchange rate regime and following an economic diversification policy or switching towards a flexible exchange rate regime to achieve price stability. In that case, the existence of a stable money demand function in Saudi Arabia is a necessary precondition for adopting a monetary policy strategy targeted to price stability using instruments like money targeting.     

Money velocity and asset prices in the euro area

Monetary growth in the euro area has exceeded its target since several years. At the same time, the money demand function seems to be increasingly unstable if more recent data are used. If the link between money balances and the macroeconomy is fragile, the rationale of monetary aggregates in the ECB strategy has to be doubted. In fact, a rise in the income elasticity after 2001 can be observed, and may reflect the exclusion of real and financial wealth in conventional specifications of money demand. This presumption is explored by means of a cointegration analysis. To separate income from wealth effects, the specification in terms of money velocity is preferred. Evidence for the presence of wealth in the long run relationship is provided. In particular, both stock and house prices have exerted a negative impact on velocity after 2001 and lead to almost identical equilibrium errors. The extended error correction model is stable over the entire sample period and survive a battery of specification tests.

Data uncertainty and the role of money as an information variable for monetary policy

In this study, we perform a quantitative assessment of the role of money as an indicator variable for monetary policy in the euro area. We document the magnitude of revisions to euro area-wide data on output, prices, and money, and find that monetary aggregates have a potentially significant role in providing information about current real output. We then proceed to analyze the information content of money in a forward-looking model in which monetary policy is optimally determined subject to incomplete information about the true state of the economy. We show that monetary aggregates may have substantial information content in an environment with high variability of output measurement errors, low variability of money demand shocks, and a strong contemporaneous linkage between money demand and real output. As a practical matter, however, we conclude that money has fairly limited information content as an indicator of contemporaneous aggregate demand in the euro area.     

Does money have a role in the inflation process? Evidence from Australia

Inflation, defined as a sustained increase in the price level, is considered a monetary phenomenon, as it can be explained within the framework of money‐demand and money‐supply relationships. In the extant literature, money growth is shown to remain causally related to inflation across countries and over time, irrespective of the exchange rate regime and stability of the money‐demand function. Nevertheless, emerging literature suggests a diminishing role of money in the conduct of monetary policy for price stability, especially under inflation targeting. Monetary policy in Australia under inflation targeting since 1993 is an example of policy that denies a relationship between money growth and inflation. The proposition that money does not matter insofar as inflation is concerned seems odd in both theory and the best‐practice monetary policy for price stability. This paper uses annual data for the period 1970–2017 and quarterly data for the period 1970Q1–2015Q1. It deploys both the Johansen cointegration approach and the autoregressive distributed lag (ARDL) cointegration approach to investigate for Australia whether money, real output, prices and the exchange rate (non‐stationary variables) maintain the long‐run price‐level relationship that the classical monetary theory suggests in the presence of such stationary variables as the domestic and foreign interest rates. As expected, the empirical findings for Australia are consistent with the classical long‐run price‐level relationship between money, real output, prices and the exchange rate. The error‐correction model of inflation confirms the presence of a cointegral relationship among these variables; it also provides strong evidence of a short‐run causal relationship between money supply growth and inflation. On the basis of a priori theoretical predictions and empirical findings, the paper draws the conclusion that the monetary aggregate and its growth rate matter insofar as inflation is concerned, irrespective of the strategy of monetary policy for price stability.     

FINANCIAL INNOVATION AND THE DEMAND FOR MONEY: EVIDENCE FROM THE PHILIPPINES

This paper tests whether financial innovations in the Philippines distorted the long-run relation between real money balances, income and interest rates. Using data for the monetary base, M1 and M3 over the period 1980–1998, we cannot reject the hypothesis that there does not exist a standard money demand relation between M1 and M3, real income and interest rates. However, when we allow for the impact of financial innovations, this finding is reversed for M1. Estimates of ECM models for these measures also show that financial innovations impacted real money balances for M1, but not M3. This evidence supports the Philippine central bank's choice of a monetary aggregate as its policy instrument to achieve its policy objectives. [E41, E58]     

A Reconsideration of Keynes' Finance Motive*

Keynes' finance motive is a much neglected part of monetary theory. This paper reassesses the meaning and importance of the finance motive and examines the distinction between it and the transactions motive. A specification of the demand function for money is proposed that takes account of the finance motive. The advantages of this specification for analytical and empirical purposes are explained. Finally, it is shown that this specification provides a satisfactory theoretical explanation for the evidence on timing between the real and monetary sectors; evidence thought by some to be inconsistent with Keynes' theory of liquidity preference.     

An empirical investigation of monetary interaction in the Korean economy

This paper conducts an econometric investigation of monetary interaction in the Korean economy over the past two decades. The study pays close attention to a critical role played by broad money and an interest rate term spread in the economy. A vector autoregression reveals two cointegrating relationships, both of which are consistent with macroeconomic theory: the first relationship corresponds to a broad money demand function, while the second represents a monetary policy rule function. The cointegrated system is then reduced to a vector equilibrium correction system, which characterizes the interaction between money demand and monetary policy rule. It is also demonstrated that the preferred model is a reliable forecasting device, suggesting that the broad money contains information about the real economy in the future.     

A macroeconometric framework for monetary policy evaluation: A case study of Pakistan

This paper attempts to establish the quantitative importance of the various channels of monetary transmission by constructing, estimating and simulating a small macroeconometric model of Pakistan's monetary sector, while using data from the monetary statistics and the monetary survey of the State Bank of Pakistan over 1976–2007. The paper elucidates that the key feature of the study of monetary policy in Pakistan has been preoccupied with neglect either of the demand or the supply function of money and shows how this may lead to imprecise policy actions and mistaken conclusions. Accordingly, we delineate the transmission mechanism of monetary policy by taking into consideration all structural money demand and money supply linkages along with the historically implied identifying assumption in the framework of a marginalized macroeconometric model. The within-sample and out-of-sample evaluations of the model are found satisfactory. The paper presents results of three policy simulations from the estimated model that highlight the impact of alternative monetary policy instruments on the monetary variables under a rule-based and a discretionary policy environment. We find that (i) the SBP subscribes to an unannounced monetary policy rule, (ii) the determination of the policy rate under the announced rule environment stabilizes the monetary sector in that convergence to full equilibrium is smooth and rapid, (iii) a 100 bps reduction in the discount rate, ceteris paribus, decreases money supply by 4.97%, and (iv) the long term implication of reducing (increasing) the reserve requirement ratio on time (demand) deposits, ceteris paribus, is only higher inflation. Finally, we establish that a 100 bps increase in interest rate increases money supply by 3.14% in full equilibrium.     

The (in)stability of money demand in the euro area: lessons from a cross-country analysis

The instability of standard money demand functions has undermined the role of monetary aggregates for monetary policy analysis in the euro area. This paper uses country-specific monetary aggregates to shed more light on the economics behind the instability of euro area money demand. Our results obtained from panel estimation indicate that the observed instability of standard money demand functions could be explained by omitted variables like e.g. technological progress that are important for money demand but constant across member countries.     

Substitution Between Money and Near-Monies in Switzerland

This paper investigates the substitutability between money and near-money assets during the period 1976 to 1996 in Switzerland. Financial developments have made a variety of instruments available to store wealth and conduct economic transactions. These developments have generated a “near money” component in households’ and businesses’ portfolio balances. It is important to evaluate the effect of “near-money” on money demand and the effectiveness of monetary policy. Towards this goal, five monetary assets: currency and demand deposits at commercial banks, demand deposits with the postal system, deposits on transaction accounts with banks, savings deposits and time deposits are considered. We evaluate the degree of substitutability among these assets using the Morishima elasticity. Results show that various monetary assets substitute for one another. Consistent with a high degree of diversification, the Morishima elasticity is significantly larger when adjustment takes place in the price of a relatively broader monetary asset as compared with a narrower one. Targeting a broad monetary aggregate captures a variety of assets that contribute to liquidity and aggregate demand, enhancing the effectiveness of monetary policy. Nonetheless, high elasticity of substitution between monetary assets has made it increasingly difficult to target money demand via changes in the interest rate. As a result, in 1999 the Swiss National Bank abandoned monetary targeting in favor of an expected inflation target.