International Review of Economics and Finance 8 1999 399–420
Structural breaks, cointegration, and speed of adjustment Evidence from 12 LDCs money demand
Augustine C. Arize
a,
, John Malindretos
b
, Steven S. Shwiff
a
a
College of Business and Technology, Texas AM University-Commerce, Commerce, TX 75429, USA
b
Global Management and Financial Consulting Inc., Clifton, NJ 07013, USA Received 25 February 1998; accepted 5 November 1998
Abstract
This article estimates a theoretically coherent and empirically robust money demand function for 12 developing countries. The modeling procedure not only tests for a regime shift in the
cointegrating equation, but also in the error correction model. Five specific hypotheses are examined. The article demonstrates that a long-run equilibrium relationship exists between
real M1 or M2 balances, real income, inflation, exchange rate, foreign exchange risk, and foreign interest rates in the countries studied. The study provides information on the speed
of adjustment to equilibrium and the median and mean time lags for adjustment of real money balances to changes in each determinant. Although our results provide more evidence against
M1 than M2, this study clearly establishes that both M1 and M2 must be considered as viable policy tools for less developed countries.
1999 Elsevier Science Inc. All rights reserved.
JEL classification: E41
Keywords: Structural breaks; Cointegration; Adjustment; LDCs money demand
1. Introduction
Economists and policymakers now widely agree that a theoretically coherent and empirically robust money demand function MDF is crucial for sound monetary
policy formulation in less developing countries LDCs, yet empirical work in this area has remained extremely sparse. See Domowitz and Elbadawi 1987 for more
on this issue.
This article deals with the relationship between real money balances and their determinants in 12 LDCs. The countries examined in the analysis include eight Asian
Corresponding author. Tel.: 903-886-5691. E-mail address
: Chuck Arizetamu-commerce.edu 1059-056099 – see front matter
1999 Elsevier Science Inc. All rights reserved.
PII: S1059-05609900025-8
400 A.C. Arize et al. International Review of Economics and Finance 8 1999 399–420
countries—India, Korea, Malaysia, the Philippines, Singapore, Sri Lanka, Taiwan and Thailand; and four African countries—Ghana, Morocco, South Africa and Tunisia.
This sample includes low- and middle-income LDCs, manufacturing and primary exporters, as well as service and remittance countries. This diversity makes the sample
reasonably representative of LDCs, and the results of the study can at least be sugges- tive of some general conclusions regarding LDCs and provide a basis to which future
studies can be compared. The results may also provide a valid comparison to the single-country studies, such as Domowitz and Elbadawi 1987 for Sudan, and Chowd-
hury 1997 for Thailand.
Recent studies of long-run money demand in LDCs have employed cointegration procedure i.e., Chowdhury, 1997; Arize, 1994, and some additionally have tested
for parameter stability of the error-correction model i.e., Arize, 1994, but not for a regime shift in the long-run cointegrating relationship. This article differs from the
existing literature, not only in its data set, but also in its empirical method. We are explicitly concerned with the stability of the long-run money demand in LDCs and
the validity of a number of hypotheses.
In this study, the five hypotheses examined are: 1 that the MDF is homogeneous of degree one with respect to the price level; 2 that the long-run real income elasticity
of the demand real money balances is unitary; 3 that real money balances measured by the narrow definition of money are preferable to those measured by the broad
definition in determining the long-run effect of monetary policy actions; 4 that the speed of adjustment is instantaneous for both a narrow definition of money real M1
and a broad definition of money real M2; and 5 that domestic money holdings in LDCs are not influenced by movements in the “openness” variables: exchange rates,
foreign interest rates and real exchange rate variability.
These hypotheses are important for a number of reasons: first, knowledge of whether the demand for nominal money balances is proportional to changes in the price level,
which, as Hafer and Kutan 1994, p. 937 pointed out, “allows us to consider which monetary measure is preferable in determining the long-run effect of monetary policy
actions.”
Second, knowledge of the size of real income elasticities allows one to determine whether there are economies of scale in cash holdings in LDCs. Aghevli et al. 1979,
p. 790 have pointed out that, “for financially developed economies, one would expect a proportional relationship between real income and real money balances, but in
developing countries the demand for money may well rise at a faster rate than income because of monetization, limited opportunities to economize on cash balances, and
the paucity of other financial assets in which to hold savings.”
Third, while the long-run effects of the determinants of real money balances are of interest, the short-run adjustment of money demand to changes in these variables also
is frequently important, especially in a policy sense. How quickly real money balances respond to changes in real income, expected inflation, exchange rate and foreign
exchange risks is important for understanding future effects that may occur as a result of changes in monetary or exchange-rate policy and for interpreting recent events.
The traditional view is that speed of adjustment to equilibrium in most LDCs is close
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
