A.C. Arize et al. International Review of Economics and Finance 8 1999 399–420 401
to unity because of higher risks and uncertainties attributable to economic and socio- political instability and the lack of a variety of financial assets available for the wealth
holders to undertake portfolio switches Adekunle, 1968; Aghevli et al., 1979. Finally, if the variables—exchange rates, foreign interest rates and real exchange
rate variability—turn out to be important determinants of real money balances, this may affect the design of monetary policy because it creates uncertainty in the outcome
of monetary policy or, as Marquez 1987, p. 168 noted, “results in a loss of government seigniorage and could precipitate a balance of payments crisis.”
The remainder of this article is set out as follows. Section 2 describes the money demand model. The empirical results are presented in Section 3, and concluding
remarks close the article in Section 4.
2. Model specification and theoretical considerations
From an empirical standpoint, there is a consensus in the literature on developing countries Arize, 1994 that the error-correction model may be written as:
m
t
2 a 2 a
1
y
t
2 a
2
p
t
2 a
3
e
t
2 a
4
s φ
t
2 a
5
r
f t
5 e
t
1 Dm
t
5 k 1 m 1 le
t
2
1
1
o
2 j
5
1
d
j
Dy
t2j
1 d
2
1
j
Dp
t2j
1 d
4
1
j
De
t2j
1 d
6
1
j
Ds φ
t2j
1 d
8
1
j
Dr
f t2j
1
o
2 j
5
b
j
Dm
t2j
2
1
2 where m
t
is the logarithm of desired holdings of real money balances real M1 or real M2; real M1 consists of currency outside the banks and demand deposits at the
scheduled banks divided by the consumer price index; real M2 consists of M1 plus quasi-money divided by the consumer price index;
1
y
t
is the logarithm of real GDP; p
t
is the expected inflation rate obtained from the consumer price index; e
t
is the exchange-rate variable, defined as the number of units of each country’s currency per
unit of U.S. dollar a similar definition is employed by Domowitz Elbadawi, 1987; s
φ
t
is a measure of real exchange-rate variability; r
f t
is a measure of foreign interest rates; and D is the first-difference operator. The stochastic disturbance terms are m
t
and e
t
. Eq. 1 has assumed that the money market is in equilibrium and it may be viewed
as a cointegrating model. The basic idea of cointegration is that two or more nonstation- ary time series may be regarded as defining a long-run equilibrium relationship if a
linear combination of the variables in the model is stationary converges to an equilib- rium over time.
2
Thus, if the money demand function describes a stationary long- run relationship among the variables in Eq. 1 this can be interpreted to mean that
the stochastic trend in real money balances is related to the stochastic trends in the real income, the rate of inflation, exchange rate and foreign exchange risk. In other
words, even though deviations from the equilibrium should occur, they are mean reverting.
402 A.C. Arize et al. International Review of Economics and Finance 8 1999 399–420
In Eq. 1, real money balances are assumed to be an increasing function of real income i.e., real GDP, as the usual budget conditions dictates; that is, a
1
is expected to be positive. On the other hand, an increase in the expected inflation rate should
lead to a substitution away from money to other real assets i.e., houses, farms or durable consumer goods, so a
2
is expected to be negative. The inclusion of exchange rate in the empirical money demand equation was origi-
nally postulated by Mundell 1963, p. 484, who wrote, “The demand for money is likely to depend upon the exchange rate in addition to the interest rate and the level
of income.” Arango and Nadiri 1981 have argued that, when domestic currency depreciates, it increases the value of foreign securities held by domestic residents. If
this increase is considered as an increase in wealth, the demand for domestic money may rise. On the other hand, Bahmani-OsKooee and Pourheydarin 1990 and Arize
1989 have argued that, as a weak domestic currency yields expectations for further weakening, asset holders would shift some of their portfolios away from domestic
currency and into foreign currencies. Therefore, an increase in the exchange rate i.e., depreciation could have a positive or negative effect on the demand for money.
Other theoretical justifications for the inclusion of the exchange-rate variable are given in Branson and Buiter 1984 and Warner and Kreinin 1983.
The effect of foreign exchange risk on real money balances also is an empirical issue. Zilberfarb 1988 suggests that there can be the substitution effect whereby
increased foreign exchange risk tends to reduce holdings of the more risky asset and thus increase holdings of domestic balances i.e., a
3
will be positive. On the other hand, Akhtar and Putnam 1980, p. 787 have argued that “the direct effect of transactor
responding to increases in the riskiness of currency values is a tendency to diversify and hold smaller amounts of domestic money. Domestic currency no longer provides
the same informational content concerning international transactions as previously and may no longer serve as an optimal store of value for a given level of transactions.”
Therefore, exchange risks could have a negative effect on real money balances i.e., a
3
will be negative. The impact of exchange-rate risk on real money balances is an empirical issue, because theory alone cannot determine the sign of a
3
. The effect of the foreign interest rate variable is inversely related to the demand
for real money balances. Work by Hamburger 1977 and Arango and Nadiri 1981 has shown that an increase in foreign interest rates ceteris paribus may induce market
participants to transfer their financial assets to the high-yielding capital markets. Such transfers will be financed by drawing down domestic money holdings, so a
5
will be negative.
Eq. 2 gives the short-run determinants of money demand and embodies both the short-run dynamics and the long-run relation of the series. e
t
2
1
is the error-correction one-lagged error term generated from the Phillips and Hansen 1990 multivariate
procedure. The presence of the e
t
2
1
in Eq. 2 reflects the presumption that actual real money balances do not adjust instantaneously to their long-run determinants.
Therefore, in the short-run, adjustments are made to correct any disequilibrium in the long-run money demand. The parameter l is the error-correction coefficient and
measures the response of the real money balances in each period to departures from equilibrium conditions. The Error-Correction Model ECM therefore reflects how
A.C. Arize et al. International Review of Economics and Finance 8 1999 399–420 403
the system converges to the long-run equilibrium implied by Eq. 1, with convergence being assured when l is between 0 and 21. In addition, the value of l depends on
the normalization of the cointegrating vector Arize Darrat, 1994.
3. Empirical results
