Front Matter Page
European Department
Contents
I. Introduction
1. Conventional money demand specifications
2. An alternative specification of money demand
3. Long-run solutions and co-integration
4. Conclusions
Text Tables
1. Money Demand Estimates
2. Money Demand Estimates
3. Co-Integration Regressions
4. Contributions to Growth in M1
Appendix I. Data
Appendix II. Diagnostics and Test Statistics
Appendix III. Recursive Estimation
Charts
1. Real Money Demand and Forecast; Koyck Lag Specification
2. Real Money Demand and Forecast; Koyck Lag Specification
3. Changes in Real Money Demand and Forecast; ADL Specification
4. Liquidity Ratio Equilibrium and its Determinants
5. Money Demand Recursive Residuals
6. Money Demand Recursive Parameter Estimate Prices
7. Money Demand Recursive Parameter Estimate Contemporaneous Exchange Rate
8. Money Demand Recursive Parameter Estimate Lagged Exchange Rate
9. Money Demand Recursive Parameter Estimate Short-Term Interest Rate
10. Money Demand Recursive Parameter Estimate Yield Curve
References
Summary
The demand for narrow money balances in the Netherlands increased markedly in relation to GNP throughout the 1980s, a phenomenon that was not observed prior to this period. The abrupt shift in velocity cannot be explained with traditional money demand functions, which consistently overpredict money demand through the mid-1980s and consistently under-predict it thereafter.
To help explain the demand for narrow money in the 1980s the analysis in this paper is extended in two ways. First, drawing on advances in dynamic modeling advocated by David Hendry, the paper estimates an autoregressive distributed lag model of narrow money balances. This specification is then reduced to result in an error corrections model, including, among other things, the effects of changes in the slope of the yield curve—the difference between long- and short-term interest rates. Second, two variables are added and incorporated in the above search for proper dynamic specification. These concern the guilder/U.S. dollar exchange rate as a potential external indicator of influence on domestic money demand as suggested in the currency substitution literature, and a cyclical indicator to help specify short-run dynamics. The long-run solution derived from the error corrections model is checked against a direct estimate of long-run narrow money demand as suggested in the literature on cointegration; the two estimates are found to be practically identical.
The analysis suggests that the behavior of money demand and of the liquidity ratio in the Netherlands during the 1980s can be reasonably well explained using this improved (dynamic) specification, and by incorporating the exchange rate. Indeed, the overprediction of Dutch money demand during the early 1980s disappears when accounting for the significant strengthening of the U.S. dollar against the guilder, and vice versa during the second half of the 1980s.
A corollary to incorporating the exchange rate variable in money demand functions is that it provides a potentially important external indicator of the stance of monetary policy. A substitution out of domestic currency into foreign currency, because, say, monetary policy is perceived by market participants as too loose, leading to fears of a depreciation, is bound to increase the domestic interest rate and decrease the exchange rate. If the monetary authorities focus myopically on signals from domestic money markets alone—the domestic interest rate increases—they might misread the stance of their policy as being too tight. If the monetary authorities view the domestic interest rate and the exchange rate jointly as monetary indicators, then they are less likely to misread these market signals.