Money Demand, Ppp and Macroeconomic Dynamics in the Dominican Republic

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I. INTRODUCTION

The impact of money on real and nominal economic variables has been approached from various perspectives. The vector autoregression (VAR) method popularised by Sims (1980) is arguably the tool macroeconomists employ the most when dealing with such a task. The extensive (mainly) monetary policy VAR literature spurred by Sims' programme is surveyed in Christiano et al (1999).

In spite of its pandemic utilisation, the VAR technique is not free of drawbacks. For instance, non-practitioners have labelled the approach atheoretical. Some of the puzzles generated by the literature (e.g. Sims, 1992) have been (partly) attributed to that flaw (e.g. Rudebusch 1998). The cointegrating VAR (CVAR) is a plausible alternative in attempting to surpass that critical obstacle . CVARs allow a cautious examination of the long and short run properties of the statistical information at hand, while enabling economic theory to be incorporated fully in the modelling process. However, the method also demands the researcher's judgement to be exercised at some points. Specimens of diverse investigations, mainly focused on advanced economies, in the spirit of such multivariate time series econometric methodology are King et al (1991), Mellander et al (1992), Fung and Kasumovich (1998), and Crowder et al (1999)2.

Although various studies have attempted to add to our understanding of macroeconomic fluctuations in developing countries through the application of the traditional VAR approach (e.g. Leiderman 1984; Reinhart & Reinhart 1991; Kamas 1995), they have not explicitly dealt with the consequential task of identifying the long run properties of the system at hand. Remarkably, doing so is crucial if sensible conclusions are to be derived from the subsequent dynamic analyses, e.g. impulse responses, of the model under scrutiny.

This paper intends to tackle that issue head on. It will do so by investigating the properties of a compact macro-monetary model of a small developing economy, namely the Dominican Republic (DR), through the application of the CVAR methodology. The proposed inquiry involves a series of questions. Particularly,

1. are standard, textbook, cointegrating economic relations identifiable in a compact set of DR macroeconomic variables?

2. If so, how quick do these relations achieve their long run equilibrium levels after being hit by a system-wide perturbation?

3. Furthermore, what are the trajectories followed by the individual variables in the system after a shock to a specific equation's residuals?

4. Is the upshot of these exercises economically sensible?

5. Which are the implications for monetary policymaking in the DR and, tentatively, similar economies?

These crucial issues are dealt with in the following fashion. Section II elucidates the theoretical aspects of the economic relations involved in the study. In section III the nature of the data is explained, and its integration and cointegration properties are ascertained. The model's underlying dynamic properties are dissected in section FV. Section V provides concluding remarks.

II. ECONOMIC BACKGROUND

Economic theory frequently suggests that certain variables enjoy a long-run relationship, i.e. are cointegrated, often with specific coefficient values. Examples of such relations are money demand, purchasing parity power (PPP), uncovered interest parity (UIP), and the Fisher equation . For instance, in a vector X containing real money, real income, an exchange rate, a foreign interest rate, and domestic and foreign prices at least a money demand and a PPP relation could be expected to hold4.

III. EMPIRICAL MODELLING

The analysis of the system X = ((m - p)^sub t^, y^sub t^, R^sub t^*', e^sub t^, p^sub t^^sup D^, p^sub t^^sup F^) involves several stages. Specifically,

1. Unit root testing: determining the order of integration of the variables to be analysed, mainly by applying the standard augmented Dickey-Fuller (ADF) (Dickey and Fuller, 1979) unit root test. …