STEPHEN M. GOLDFELD
DANIEL E. SICHEL*
Board of Governors of the Federal Reserve System
Introduction Overview of empirical difficulties
2.1. 2.2. U.S. money demand Money demand: International evidence A brief theoretical overview A variable-by-variable review Money demand and the partial adjustment mechanism Criticisms and modifications of the partial adjustment model Dynamic models that impose long-run relationships Simultaneity, exogeneity, and the nature of the adjustment process
Re-examining the basic specification
300 302 302 306 308
4.1. 4.2. 4.3. 4.4.
5. Concluding remarks References
313 324 325 333 338 341 349 353
* We thank Benjamin Friedman for his comments. The opinions expressed are those of the authors; they do not necessarily reflect the views of the Board of Governors of the Federal Reserve System.
Handbook of Monetary Economics, Volume I, Edited by B.M. Friedman and F.H. Hahn © Elsevier Science Publishers B.V., 1990
S.M. Goldfeld and D.E. Sichel
I. Introduction The relation between the demand for money balances and its determinants is a fundamental building block in most theories of macroeconomic behavior. Indeed, most macroeconomic models, whether theoretical or econometric, generally ignore the rich institutional detail of the financial sector and attempt to capture financial factors via the demand and supply of money. Furthermore, the demand for money is a critical component in the formulation of monetary policy and a stable demand function for money has long been perceived as a prerequisite for the use of monetary aggregates in the conduct of policy. Not surprisingly, then, the demand for money in many countries has been subjected to extensive empirical scrutiny. The evidence that emerged, at least prior to the mid-1970s, suggested that a few variables (essentially income and interest rates, with appropriate allowance for lags) were capable of providing a plausible and stable explanation of money demand. As has been widely documented, especially for the United States but elsewhere as well, matters have been considerably less satisfactory since the mid-1970s. First, there was the episode of the "missing m o n e y " when conventional money demand equations systematically overpredicted actual money balances. Moreover, attempts to fit conventional demand functions to a sample that included the missing money period invariably produced parameter estimates with some quite unreasonable properties. Second, in the 1980s, U.S. money demand functions, whether or not fixed up to explain the 1970s, generally exhibited extended periods of underprediction as observed velocity fell markedly. To be sure, the period since the mid-1970s has been marked by unusual economic conditions in many countries including supply shocks, severe bouts of high and variable inflation, record-high interest rates, and deep recessions. The period also coincided with the widespread adoption of floating exchange rates and, in a number of major industrial countries, with substantial institutional changes brought about by financial innovation and financial deregulation. Where institutional change was particularly marked, it also led to a change in what we think of as " m o n e y " . The period since 1974 thus provided a very severe test of empirical money demand relationships and it is perhaps not so surprising that this period succeeded in exposing a number of shortcomings in existing specifications of money demand functions. 1 lit is perhaps ironic that the emergence of these shortcomings roughly coincided with the adoption by a number of central banks of policies aimed at targeting monetary aggregates. Some have argued that this association is more than mere coincidence. In any event, given the vested interest of policymakers in the existence of a reliably stable...