Money demand function

Topics: Money supply, Inflation, Monetary policy Pages: 91 (7643 words) Published: December 10, 2013
INSTITUTE OF DEVELOPING ECONOMIES
IDE Discussion Papers are preliminary materials circulated
to stimulate discussions and critical comments

IDE DISCUSSION PAPER No. 166

An Empirical Analysis of the Money
Demand Function in India
Takeshi INOUE * and
Shigeyuki HAMORI **
September 2008
Abstract
This paper empirically analyzes India’s money demand function during the period of 1980 to 2007 using monthly data and the period of 1976 to 2007 using annual data. Cointegration test results indicated that when money supply is represented by M1 and M2, a cointegrating vector is detected among real money balances, interest rates, and output. In contrast, it was found that when money supply is represented by M3, there is no long-run equilibrium relationship in the money demand function. Moreover, when the money demand function was estimated using dynamic OLS, the sign conditions of the coefficients of output and interest rates were found to be consistent with theoretical rationale, and statistical significance was confirmed when money supply was represented by either M1 or M2. Consequently, though India’s central bank presently uses M3 as an indicator of future price movements, it is thought appropriate to focus on M1 or M2, rather than M3, in managing monetary policy.

Keywords: cointegration, DOLS, India, money demand
JEL classification: E41, E52

* Institute of Developing Economies (takeshi_inoue@ide.go.jp). ** Faculty of Economics, Kobe University (hamori@econ.kobe-u.ac.jp).

The Institute of Developing Economies (IDE) is a semigovernmental, nonpartisan, nonprofit research institute, founded in 1958. The Institute merged with the Japan External Trade Organization (JETRO) on July 1, 1998. The Institute conducts basic and comprehensive studies on economic and related affairs in all developing countries and regions, including Asia, the Middle East, Africa, Latin America, Oceania, and Eastern Europe.

The views expressed in this publication are those of the author(s).

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INSTITUTE OF DEVELOPING ECONOMIES (IDE), JETRO
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©2008 by Institute of Developing Economies, JETRO
No part of this publication may be reproduced without the prior permission of the IDE-JETRO.

An Empirical Analysis of the Money Demand Function in India

Inoue Takeshi
(Institute of Developing Economies)
and
Shigeyuki Hamori
(Faculty of Economics, Kobe University)

Abstract

This paper empirically analyzes India’s money demand function during the period of 1980 to 2007 using monthly data and the period of 1976 to 2007 using annual data. Cointegration test results indicated that when money supply is represented by M1 and M2, a cointegrating vector is detected among real money balances, interest rates, and output. In contrast, it was found that when money supply is represented by M3, there is no long-run equilibrium relationship in the money demand function. Moreover, when the money demand function was estimated using dynamic OLS, the sign conditions of the coefficients of output and interest rates were found to be consistent with theoretical rationale, and statistical significance was confirmed when money supply was represented by either M1 or M2. Consequently, though India’s central bank presently uses M3 as an indicator of future price movements, it is thought appropriate to focus on M1 or M2, rather than M3, in managing monetary policy.

JEL classification : E41; E52
Keywords : Cointegration; DOLS; India; Money Demand

1.

Introduction

In India, financial sector deregulation was undertaken beginning in the mid-1980s, when steps like the introduction of 182-day Treasury bills, lifting of the call money interest-rate ceiling, and the introduction of certificates of deposit and commercial paper were taken in a bid to make the government...

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