The demand for money has been perhaps the most comprehensively studied of all economic relationships over the past ten years. In addition to the natural academic interest in the determinants of demand for an important financial asset, research has been spurred by the operational importance of the relationship in circumstances where central banks have increasingly come to use rates of growth of monetary aggregates as proximate targets for policy. 1 Improving understanding of the demand for money is particularly important in the formulation of economic programs supported by assistance from the International Monetary Fund. Such programs typically involve performance criteria that set limits on the aggregate domestic lending of the banking system, either directly or through limits on the growth of the monetary base. The formulation of targets in this way is based implicitly on the assumption that there is a stable demand function for money. Given an objective or forecast for the rate of price increase, and an assumption concerning the potential of an economy for real economic growth, a certain rate of monetary expansion will then be consistent with the growth in demand for money implied by these assumptions. If a forecast or target for the likely balance of payments outturn is then added, the appropriate rate of domestic credit expansion can be determined. Credit expansion above or below this rate will cause a divergence of monetary growth from the planned rate, resulting in inflationary or deflationary pressures and tending to bring about a deterioration or improvement in the balance of payments. 2
It is recognized, of course, that the simple model sketched above is no more than a first approximation of complex economic forces that may be at work. In devising a financial program for an economy, modifications must therefore be made to take into account, as far as possible, the special circumstances of individual cases. In particular, it is important to refine the underlying estimate of the demand for money beyond simple (but often useful) heuristic assumptions such as that the demand for money grows in step with nominal income, that is, the assumption of constant velocity.
Since the revival of interest in the demand for money, which could perhaps be considered to have begun with Friedman’s (1956) restatement of the quantity theory, understanding of this basic relationship has improved in a number of respects. In financially sophisticated economies, refinements have been introduced to incorporate the influence of changes in economic structure, demographic shifts, the availability of a complex array of alternative financial assets, and the influence on money demand of different patterns of lagged adjustment to changes in its principal determinants. Understanding of the money demand relationship has also been broadened by studies undertaken for a variety of economies at different stages of development and with different economic structures.
At the risk of oversimplification, the body of evidence now available permits a number of generalizations. First, in many different circumstances a demand for money function can be estimated with sufficient stability to be operationally useful. Second, the two most important determinants of the demand for real money balances are a scale variable providing some measure of the volume of transactions in the economy and an opportunity cost variable measuring the return (expected or actual) on holding money relative to alternative assets, real or financial. Third, the coefficients of the various determinants of the demand for money vary between economies with different structural characteristics. Estimates of the determinants of the demand for money obtained from data for industrial countries cannot, therefore, be extrapolated with confidence for the purpose of making policy prescriptions in developing countries.
The main purpose of this study is to estimate money demand functions for all countries in the Middle Eastern Department of the Fund for which data are available. 3 It needs to be stressed, however, that an exercise of this kind has inevitable limitations. The available statistical estimates for a number of important variables in the demand for money function are generally less reliable than those for more developed economies. In a number of cases, time series are too short to permit a high degree of confidence in the resulting estimates. Furthermore, income data are usually available only on an annual basis, thus precluding the estimation of anything more than the most rudimentary lag structure. Also, many of the economies in the region have been going through a process of rapid structural change, which may well be reflected in changes in the underlying determinants of money demand.
The plan of this paper is as follows. Section I discusses a number of theoretical and practical problems involved in estimating the demand for money in the countries to be studied. Section II presents the basic model and provides individual country estimates for the estimated equations. Section III presents some results derived from pooling data across countries. Section IV discusses the statistical procedures employed and the interpretation of the results. Finally, Section V assesses some of the conclusions that can be drawn.
APPENDIX: Data Sources and Definitions and Estimation Results
Adekunle, Joseph O., “The Demand for Money: Evidence from Developed and Less Developed Economies,” Staff Papers, Vol. 15 (July 1968), pp. 220–66.
Aghevli, Bijan B., Mohsin S. Khan, P. R. Narvekar, and Brock K. Short, “Monetary Policy in Selected Asian Countries,” Staff Papers, Vol. 26 (December 1979), pp. 775–824.
Chow, Gregory C., “Tests of Equality Between Sets of Coefficients in Two Linear Regressions,” Econometrica, Vol. 28 (July 1960), pp. 591–605.
Fan, Liang-Shing, and Zeng Rung Liu, “Demand for Money in Asian Countries: Empirical Evidence,” Indian Economic Journal, Vol. 18 (April-June 1971), pp. 475–81.
Fisher, Franklin M., “Tests of Equality Between Sets of Coefficients in Two Linear Regressions: An Expository Note,” Econometrica, Vol. 38 (March 1970), pp. 361–66.
Friedman, Milton, “The Quantity Theory of Money—A Restatement,” in Studies in the Quantity Theory of Money, ed. by Milton Friedman (University of Chicago Press, 1956), pp. 3–21.
Galbis, Vicente, “Money, Investment, and Growth in Latin America, 1961-1973,” Economic Development and Cultural Change, Vol. 27 (April 1979), pp. 423–43.
Hynes, A., “The Demand for Money and Monetary Adjustments in Chile,” Review of Economic Studies, Vol. 34 (July 1967), pp. 285–93.
Khan, Mohsin S., “Variable Expectations and the Demand for Money in High-Inflation Countries,” Manchester School of Economic and Social Studies, Vol. 45 (September 1977), pp. 270–93.
Khetan, C. P., and R. R. Waghmare, “Monetary Adjustments in India,” Indian Economic Journal, Vol. 18 (April-June 1971), pp. 496–513.
Morgan, David R., “Fiscal Policy in Oil Exporting Countries, 1972-78,” Staff Papers, Vol. 26 (March 1979), pp. 55–86.
Paljarvi, Jukka M. T., and Massimo Russo, “Demand for Money, Credit Ceilings, and the Balance of Payments: A Case Study—Zambia” (unpublished, International Monetary Fund, October 17, 1978).
Perlman, Morris, “International Differences in Liquid Assets Portfolios,” in Varieties of Monetary Experience, ed. by David Meiselman (University of Chicago Press, 1970), pp. 297–337.
Polak, J. J., “Monetary Analysis of Income Formation and Payments Problems,” Staff Papers, Vol. 6 (November 1957), pp. 1–50.
White, William H., “Improving the Demand-for-Money Function in Moderate Inflation,” Staff Papers, Vol. 25 (September 1978), pp. 564–607.
Wong, Chorng-huey, “Demand for Money in Developing Countries: Some Theoretical and Empirical Results,” Journal of Monetary Economics, Vol. 3 (January 1977), pp. 59–86.
Mr. Crockett, an Advisor in the Middle Eastern Department, is a graduate of Cambridge University and Yale University.
Mr. Evans, a summer intern in the Middle Eastern Department when this paper was prepared, is a graduate of the University of Sydney, Australia. He is currently pursuing dissertation research at the University of Pennsylvania.
For a comprehensive review of the theoretical and empirical literature relating to the demand for money, see Laidler (1977).
The countries included in this study are Afghanistan, Bahrain, Egypt, Ethiopia, Iran, Iraq, Jordan, Kuwait, Lebanon, Libyan Arab Jamahiriya, Oman, Pakistan, Qatar, Saudi Arabia, Sudan, Syrian Arab Republic, the United Arab Emirates, the Yemen Arab Republic, and the People’s Democratic Republic of Yemen.
For example, foreign currency balances may be held as savings by residents spending prolonged periods outside the country or by firms exercising foreign exchange retention privileges.
It is of interest to note that the monetary authorities of the United Kingdom, for example, express their principal objective for monetary expansion in terms of the domestic currency liabilities of the banking system only.
A broad description of the data sources used is provided in the Appendix; a complete set of data is available on request from the authors, whose address is Middle Eastern Department, International Monetary Fund, Washington, D.C. 20431.
The results of these tests are not reported here; they are available on request from the authors (see n. 7).
Money demand studies in developed countries suggest an opportunity cost elasticity of between—0.2 and—0.8, in general.
Strictly speaking, it suggests that monetization is proceeding at the same pace relative to per capita income growth.