ABSTRACT
In the flow of funds model for the household sector, this chapter provides a new interpretation of the demand for money in developing economies.A stable demand for money function provides a reliable link for macroeconomic policy between changes in monetary aggregates and changes in variables in the demand for money function (Siddiki 1984). In developing countries, money demand is often found to be the only reliable aggregate relationship, again in part because data availability limits the estimation of other relationships. In recent studies, open economy factors, such as foreign interest rates and exchange rates, have been shown to be important in the determination of money demand, especially in countries where there has been rapid financial market liberalisation (e.g. Arize 1994 and Khalid 1999). However, all these studies involve the estimation of the demand for money as a single equation. In contrast, we model household portfolio behaviour as a whole. We can therefore analyse the demand for money as an integral part of the system and examine more rigorously, and in a much richer setting, the substitution effects between money and other financial assets. The use of the AIDS model also permits the analysis of the demand for money from the standpoint of consumer demand theory, rather than considering explicit motives for holding money. We use our results to examine the scope for monetary policy by investigating the nature of the demand for money function in the context of the flow of funds system. The rest of the chapter is organised as follows. Section 8.2 sets out the data
collection procedures, details the financial instruments that are used in the model and sets out the explanatory variables. In Section 8.3 we discuss the econometric methodology and the tests for co-integration. The results of unit root tests, cointegration, and hypothesis tests are presented in Section 8.4, where we also derive a restricted long-run model from the general to specific methodology. Inferences from the restricted long-run model are summarised in Section 8.5. In Section 8.6, we compare our results with the existing empirical evidence on the demand for money in developing economies in a single-equation framework. Some concluding remarks are contained in Section 8.7.
