IMPROVING REVEALED PREFERENCE BOUNDS ON DEMAND RESPONSES*

There are three key dimensions by which revealed preference bounds on consumer demand responses can be improved. The first relates to the improvements that arise from using expansion paths for given relative prices, E‐bounds. The second concerns the addition of new price information. Thirdly, there are improvements due to assuming separability. Our previous research has examined the first two cases. In this article, we show how to impose separability assumptions within a fully nonparametric analysis and distinguish between weak and homothetic separability. We also apply these ideas to the analysis of demand responses using United Kingdom household level data.     

A characterization of piecemeal second best policy

This paper derives conditions under which prices may be set proportional to marginal cost in some sectors of the economy when fixed distortions exists in other sectors. Two simple neoclassical economies are considered - one with fixed producer prices and one with variable producer prices. In the former case, nacessary and sufficient conditions are derived for piecemeal policy in terms of properties of derivatives of the demand functions. These conditions are then interpreted in terms of separability properties of utility functions where we find that only weak separability is required. In the latter case, sufficient conditions are derived which involved both demand and supply derivatives. These are also interpreted in terms of separability properties of utility and production functions. The analysis differs from previous ones in that we use a dual formulation of the problem and obtain conditions in terms of demand and supply derivatives which are observable, and we explicitly take into consideration the budgetary constraint of the government. Because of the latter, the factor of proportionality in applying piecemeal policy is not necessarily unity. So, in general, complete laissez faire is not optimal.     

Stock prices and long-run demand for money: evidence from Malaysia

This paper investigates the money demand function for Malaysia in the 1971-1996 period using the multivariate cointegration and error correction model methodology. The results suggest that a stable long-run relationship exist between real M2, the interest rate differential, income and stock prices. Stock prices have a significant negative substitute effect on long-run as well as short-run broad-money demand (M2) and its omission can lead to serious misspecification in the money demand function. The analysis from the vector error correction model (VECM) and the Toda & Yamamoto (1995) causality tests find that money is endogenous and that there is at least a unidirectional relationship between stock prices and real M2. Stock prices Granger cause real M2 indirectly through income between interest rates and stock prices and stock prices and money stock. This paper comes to the conclusion that due to the endogeneity of money, M2 cannot be completely controlled by Malaysia's central bank. Therefore, in formulating future monetary policy, the response of money demand to stock prices should be considered.     

Money,nonconvex preferences,and the existence of equilibrium: A note

Nonconvexities play a major role in several theories of money. This note suggests an additional such role. In particular, an economy is presented which fails to have a competitive equilibrium in the absence of fiat money. When fiat money is present, a steady-state competitive, equilibrium does exist and has the feature that money necessarily has value. This is because in any steady state, monetary equilibrium relative prices are bounded in such a way that the discontinuous portions of excess demand functions may become irrelevant.     

Exchange rate volatility and the demand for money in the U.S.

This paper examines the effect of changes in the level and volatility of exchange rates on the demand for money. It hypothesizes that exchange rate volatility exerts a negative influence on money demand separate from the effect of the level of exchange rates. Using U.S. data covering the period from 1974.1 to 1990.4, it is found that, regardless of whether the adjustment process is modeled as an error-correction or a partial-adjustment model, exchange rate volatility is negatively related to the demand for real M2 balances. This relationship is found to be more pronounced when exchange rates are expressed in real terms. The results imply that money demand responds to both the volatility of domestic prices relative to foreign prices and to the volatility of nominal exchange rates. Little evidence is found in support of the hypothesis that the level of exchange rates exerts a significant influence on money demand.     

Joint Allocation of Leisure and Consumption Commodities: A Japanese Extended Consumer Demand System 1979—90

In this study we estimate the parameters of a household expenditure function which includes joint choice of leisure and consumption commodities in scope without a separability assumption. We have used Japanese prices, wage rate, labour supply, and expenditure data on ten commodity groups, collected from 47 cities over 12 years. This data set has the advantage that separate observations are available for each data point for all the variables. We employed the AI demand system, for estimation. Controlling for time-specific effects, the result implied a definite rejection of the weak separability of labour supply and commodity choice, and non-rejection of the homogeneity and symmetry restrictions on the demand system. All the own-price elasticities are significantly negative, and both substitutes and complements are observed across commodity groups. As for the negativity, all but one of the eigenvalues of the substitution matrix are negative. The result as a whole showed consistency with demand theory. The estimated compensated labour supply elasticity is 0.39, which is in reasonable agreement with the previous studies.     

A note on the speculative demand for money

In the General Theory, Keynes argued that expectations about future bond prices tend to be “sticky”. A rise in bond prices causes more investors to “join the bear brigade” and so increases the aggregate demand for money. Since Tobin's classic article on liquidity preference, this explanation of the downward sloping demand for money curve has largely disappeared from the literature. This note introduces sticky expectations into the Tobin framework. It shows that the existence of such stickiness does not necessarily cause the demand for money to be more elastic because investors have expectations about the variance of future bond prices as well as about their mean. A sufficient condition for a more elastic demand for money under sticky expectations is that the Pratt-Arrow coefficient of relative risk aversion be either constant or decreasing in wealth.     

An investigation of issues relating to where energy should enter the production function

This paper examines the impact of imposing different separability assumptions in the specifications of the standard hierarchical KLEM production function in a computable general equilibrium (CGE) model. The appropriate means of introducing energy to production functions has been a source of debate for a number of years. However, while modellers often subject results to parametric sensitivy analysis regarding the values associated with elasticities of substitution between inputs, it is rarely the case that the structure of the production function is subjected to testing. However, the chosen structure reflects the modeller's view about elasticity between different inputs and will have implications for model results wherever there are changes in relative prices. We illustrate our argument by introducing a simple demand shock to a CGE model of the Scottish economy (targeted at the energy supply sector) under different assumptions regarding the structure of the KLEM production function and separability assumptions therein.     

A note on uncertainty, liquidity, and stock prices

This paper presents theory and some empirical evidence on the relationship between the demands for money and stocks and bonds in the presence of changes in the volatility of money growth. Theoretically, it is shown that with variable velocity, an increase in the conditional variance of money growth triggers an increase in the demand for money relative to stocks and bonds with a consequent reduction in stock and bond prices. Empirically, the model only performs well in the dimension of stocks and bond prices moving in the same direction.     

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.     

The demand for divisia M1, M2, and M3 in the United States

This paper analyzes the demand for broad money measures and estimates the degree of substitution between Divisia money, defined from narrow to broad, and the “nested like assets” at different levels of aggregation. The analysis is conducted within a microtheoretical framework-utilizing the demand-system approach- and makes use of the Strotz-Gorman multistage optimization framework. Another pleasing feature of our approach is the systematic testing for the appropriateness of the weak separability (aggregation) conditions at the various levels of aggregation.     

On the empirical relevance of the Lucas critique: the case of euro area money demand

This paper examines the relevance of the Lucas critique for euro area money demand. Based on the money in the utility function approach, a vector error correction model is specified to investigate the relationship between money and inflation in times of policy shifts. A well defined equation for money demand is obtained. The results indicate that the evolution of M3 is still in line with money demand. In the long run, inflation is affected by asset prices and detrended output. Our results show that the Lucas critique can be refuted in case of euro area money demand for the period of quantitative easing. Thus, the estimated money demand equation provides reliable information for the conduct of future monetary policy.     

THE MONEY DEMAND FUNCTION FOR THE EURO AREA: SOME EMPIRICAL EVIDENCE

This paper sets out to re‐examine the money demand function for the euro area. Traditional specifications often yield unsatisfactory results: instability of short and long‐term coefficients; relatively large differences between estimated and actual value of variables; and significant changes in the number of long‐term relationships, etc. Using a standard Vector Error Correction Model, we find that the usual specification is indeed unstable. However, introducing a European equity price gives rise to a more stable system. Furthermore, recursive estimates confirm the relative stability of long‐term coefficients. Estimates of the real money gap, based on the money demand equation including equity prices, point to moderate, albeit persistent, excess liquidity in the euro area in recent years. The real money gap contains information about future inflation but this content may have diminished since 2001.     

Money Demand and Purchasing Power Parity (PPP), in the Republic of South Africa

We have examined empirically two important economic relationships, the Purchasing Power Parity (PPP) and the money demand relationship, among the consumer prices, money, output, interest rates, and the nominal rand/dollar exchange rate of the Republic of South Africa (RSA) for the sample period from 1993 second quarter to 2003 second quarter within the frameworks of co-integration and Error Correction Model (ECM). It is established that the strong version of the PPP including the proportionality and the symmetry hypothesis, is supported. The changes in the rand/dollar exchange rates are influenced by the long term trends in the consumer prices of the RSA and the USA. There also exists a well defined money demand function for this period. The broad money demand is influenced by the consumer prices, the GDP and the interest rates. The short-term interest rates are found to be the own rate of return for broad money and the long-term bond yield is the opportunity cost of holding money. The monetary policy works through the short term interest rates.

     

Welfare analysis in a two-stage inverse demand model: an application to harvest changes in the Chesapeake Bay

Like many agricultural commodities, fish and shellfish are highly perishable and producers cannot easily adjust supply in the short run to respond to changes in demand. In these cases it is more appropriate to conduct welfare analysis using inverse demand models that take quantities as given and allow prices to adjust to clear the market. One challenge faced by economists conducting demand analysis is how to limit the number of commodities in the analysis while accounting for the relevant substitutability and complementarity among goods. A common approach in direct demand modeling is to assume weak separability of the utility function and apply a multi-stage budgeting approach. This approach has not, however, been applied to an inverse demand system or the associated welfare analysis. This paper develops a two-stage inverse demand model and derives the total quantity flexibilities which describe how market clearing prices respond to supply changes in other commodity groups. The model provides the means to estimate consumer welfare impacts of an increase in finfish and shellfish harvest from the Chesapeake Bay while recognizing that harvests from other regions are potential substitutes. Comparing the two-stage results with single-stage analysis of the same data shows that ignoring differentiation of harvests from different regions, or the availability of substitutes not affected by a supply shock, can bias welfare estimates.     

Stock Market Fluctuations and Money Demand in Italy, 1913–2003

This paper examines the impact of stock market fluctuations on money demand in Italy from a long‐run perspective. The money demand function estimated by Muscatelli and Spinelli (2000) for a long time span is utilized as a benchmark, adding to the specification information on share prices from the Milan Stock Exchange Reform of 1913 to recent years. For a shorter time period (1938–2003), annual observations on stock market capitalization and turnover velocity are also considered. The empirical findings suggest that stock market fluctuations help to explain temporary movements in liquidity preference, rather than its secular patterns. Overall, a positive association emerges between an index of stock market prices that includes dividends and real money balances; however, the estimated long‐run relationship is unstable. In a dynamic, short‐term specification of money demand, the estimated coefficient of deflated stock prices is positive, and therefore compatible with a wealth effect, in the years 1913–1980, while in the last two decades a substitution effect has prevailed and the correlation between money and share prices has been negative. This is likely to reflect a change in financial structure and the increasing role of opportunity costs defined over a wider range of assets. These results are confirmed by data on stock market capitalization. Moreover, in the recent period, stock market turnover and money growth are positively correlated .     

The workings of a commodity money system in an incomplete information macro model

This paper compares the properties of a token money system with that of a commodity money system in an uncertain environment. In an incomplete information world, relative prices are not known with certainty. However, a commodity money system provides some information because the nominal price of the monetary commodity is known. The benefits of this information-enhancing function may be offset, though by distortions in relative prices relative to their full information Walrasian equilibrium values. Because the two systems have vastly different structural parameters, we cannot unambiguously state which system is welfare superior.     

Long-run money demand in OECD countries: what role do common factors play?

This article examines the long-run money demand function for 11 OECD countries from 1983Q1 to 2006Q4 using panel data. The distinction between common factors and idiosyncratic components using principal component analysis allows for the detection of cross-member cointegration and the determination as to whether national or international sources are responsible for the non-stationarity of money and its determinants. Indeed, the finding that the common factors are I(1) while the idiosyncratic components are I(0) indicates that cross-member cointegration may exist and non-stationarity in the variables is primarily driven by common international trends. Furthermore, it is found that the impact of income on money demand is positive, whereas it is negative for the interest rate, exchange rate and stock prices. Except for the income elasticity of money demand, all estimated long-run coefficients are larger for the common factors of the variables than for the variables themselves. This article provides evidence that the exchange rate is an important determinant of money demand, whereas the results for the stock prices are ambiguous. Finally, the results of a panel-based error-correction model suggest that several domestic money stocks converge to a common international equilibrium relationship between the common factors.     

MONETARY ANTICIPATONS AND THE DEMAND FOR MONEY SOME UK EVIDENCE*

The Carr-Darby ‘shock-absorber’ hypothesis, that unanticipated changes in the money supply influence the demand for real money balances but anticipated changes do not, is tested on UK data for narrow money, M1. For comparison with earlier studies on US data we take the (real first order) partial adjustment model as one example of a ‘conventional’ demand for money function. However the Carr-Darby hypothesis is also tested taking a more general autoregressive distributed lag model as the ‘conventional’ demand function. For both ‘conventional’ demand for money functions we find that the shock-absorber hypothesis is not supported for M1 using UK data.     

Money demand instability and real exchange rate persistence in the monetary model of USD–JPY exchange rate

This paper proposes a hybrid monetary model of the dollar–yen exchange rate that takes into account factors affecting the conventional monetary model's building blocks. In particular, the hybrid monetary model is based on the incorporation of real stock prices to enhance money demand stability and also, productivity differential, relative government spending, and real oil price to explain real exchange rate persistence. By using quarterly data over a period of high international capital mobility and volatility (1980:01–2009:04), the results show that the proposed hybrid model provides a coherent long-run relation to explain the dollar–yen exchange rate as opposed to the conventional monetary model.