ABSTRACT
Define high-powered money in terms of the balance sheet items, such that
Every change in high-powered money is associated with changes in R and/or changes in all domestic influences on the balance sheet, summarised by the variable D. Substituting (2) into (1) gives the money supply formula
Demand for money is given the simple form:
(3)
(4)
(5)
Continuous equilibrium in the money market implies~ PyMe a.(R+D)=~
and therefore it is expected to be positive and in the neighbourhood of unity. For given interest rate, price level, money multiplier, and domestic credit (D), growth in income is associated with reserve inflows, according to the hypothesis. Specifically, a 1 per cent growth in income generates an (Xl per cent increase in demand for money, and consequently a reserve inflow just sufficient to result in an (Xl per cent increase in nominal and real money stock. 5
Increases in the interest rate are associated with reserve outflows in this hypothesis, a result that runs counter to intuition unless the interest rate variable is interpreted in a particular way. Namely, 'the' interest rate is viewed as a proxy for world interest rates, and changes in this interest rate are taken to reflect similar movements in rates all around the world. If this assumption is accurate, then estimates of (X2 should be negative and within the· range that is reasonable for interest elasticities of demand for money. However, if changes in Australian interest rates are dominated by changes relative to the rest of the world, then estimates of (X2 are likely to be positive. 6
consider here the conditions under which they will take the hypothesised values of + 1 . 0 for gp, and -1' 0 for both ga and (Dj H)g D' In the extreme case where the error terms in equation (5), and hence in equation (7) are everywhere equal to zero, the estimated coefficients for gp, ga, and (D/H)gD would be precisely +1'0, -1'0, and -1,0.
