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The work on the paper was initiated in the Middle Eastern Department. Thanks are due to the collegues there, especially the team working on the Islamic Republic of Iran. Thanks also to Steve Barnett, Gunnar Jonsson and Mario Mesquita for useful comments and suggestions. Special thanks to Anders Warne and Henrik Hansen for the RATS code used to estimate the model. All remaining errors are obviously the author’s sole responsibility.
The concept of a money demand relationship is not arrived at without assumptions regarding the exogenous status of the other variables in the money demand equation and in the empirical part of the paper, it turns out that the other variables are not weakly exogenous. Citation marks are thus added to indicate that “money demand” or “income elasticity” is an equations/parameter that on the surface looks as these concepts in the theoretical models, but lack the structural interpretation.
The conditions for the effects on the trade balance of changes in the exchange rate will depend on the price elasticities of the trade balance, and it is relatively straight forward to imagine that these elasticities will be dependent on the time horizon considered.
A number of measures could be used for the money stock, and here broad money is used since it is the only series that can be found for the entire sample period. If data can be found for other monetary aggregates, it could be interesting to see if the main conclusions are valid also for these aggregates.
Since the focus in money demand models is on consumer behavior, it is natural to use CPI as the measure of the domestic price level, although there obviously are several alternative measures of the price level, e.g., the GDP deflator.
Both the amount of transactions and the level of real income can be approximated by real GDP, where nominal GDP has been converted to real GDP by using the CPI rather than the GDP deflator, since the price measure used should be consistent with the calculation of real GDP.
The nominal exchange rate is slightly difficult in Iran, due to the multiple exchange rates and a number of restrictions in the exchange market. However, the black/free market rate adjusts continuously over time, which makes it a candidate for the nominal exchange rate.
Foreign prices can be measured in a number of ways. Given that the exchange rate is in dollars, the price level has to be measured in dollars, but the question of what countries to include still remains. There are at least two candidates that appear reasonable, the US price level, or a trade-weighted average of the world price level expressed in dollars. However, the latter measure involves unilateral exchange rate movements in other currencies vis a vis the dollar, and that can show up quite strongly in the measure of the foreign price level. In the case PPP was valid on a global scale with rapid adjustment, this would not be a problem, however, if this is not a valid assumption the US price level is likely to be a better measure.
Measured by the international oil price in US dollars deflated by the US CPI, more specifically Dubai, Fateh 32 API, fob Dubai which is the only price available for the entire period in the IMF database.
The end of period refers to the Iranian year, which ends in March, e.g., what is labeled here as 1996 covers March 21 1996 to March 20 1997 and corresponds to the Iranian year 1375.
There are however some caveats with respect to the critical values used here. First, the asymptotic distribution will in general change with the inclusion of exogenous variables, and secondly, the asymptotic distributions are not always the best thing to use in small sample. Given the relatively clear cut results that the asymptotic critical values render, and the fact that a fair amount of judgment always has to go into the study of cointegration and that the results are in correspondence with the theory, it does not at this point seem too necessary to simulate the appropriate empirical distributions.
However, the reader who disagrees with the null of zero I(2) components can employ the, in that case, more appropriate joint test. In that event, there are indications of a potential I(2) component, which will be ignored in the following presentation. In that case, a reformulated model including real money, real output, the inflation rate and PPP can be used to remove the potential I(2) component. However, such model suffers from other specification problems and has therefore not been developed further.
Note that the zero in the top right hand corner of the A matrix does not come from the estimation but from the identification.
Note that the coefficient are restricted by the cointegrating vectors as well as by the identifying assumption, so that in fact there is only four free parameters to estimate, which explains that some coefficients are the same.
These graphs can basically be obtained by taking the appropriate linear combinations of the impulse responses of the original series, although to generate the confidence bounds the model is reestimated with the cointegrating vectors as two of the variables and appropriate adjustment of the cointegrating vectors.
For example, the stochastic trends contain both a deterministic drift and a permanent shock, and here the focus is on the unexplained variation, i.e., the shock. Since the underlying model includes exogenous stochastic variables, the variance decomposition is done conditional on the movements in these variables.