Academic journal article Journal of Economics and Finance

Exchange Rate Volatility and Demand for Money in Less Developed Countries

Academic journal article Journal of Economics and Finance

Exchange Rate Volatility and Demand for Money in Less Developed Countries

Article excerpt

Abstract One implication of currency substitution is that the exchange rate could serve as another determinant of the demand for money. Indeed, many studies have justified this empirically for the majority of countries. If the exchange rate serves as a determinant of the demand for money, exchange rate volatility could also influence money demand. By using annual data from 15 less developed countries and the bounds testing approach, we show that exchange rate volatility has short-run effects on the demand for real M2 monetary aggregate in LDCs. However, in most countries, short-run effects are not sustained.

Keywords Money Demand · Exchange Rate Volatility · Bounds Testing Less Developed Countries

JEL Classification E41 · F30

(ProQuest: ... denotes formulae omitted.)

1 Introduction

The first of many studies that introduced the idea of including the exchange rate as another determinant of the demand for money in the money demand function was by Robert Mundell (1963). Since he made this argument without any empirical proof, many studies followed and empirically justified the link between exchange rate changes and the demand for money. These studies all emphasize that the demand for money depends not only on the interest rate and income, but also on the exchange rate. A study conducted by Arango and Nadiri (1981) explained and empirically proved that when a domestic currency depreciates, foreign currency appreciates and the domestic currency value of foreign assets held by domestic residents rises. This causes the demand for money to increase because of the domestic perception of an increase in wealth. On the other hand, Bahmani-Oskooee and Pourheydarian (1990) argued when domestic currency depreciates, this can most certainly cause market participants to expect further depreciation, causing the public to demand less domestic currency and more foreign currency.1 Thus, rather than raising the demand for money, a depreciation could have a negative impact on the demand for domestic currency. The end result depends on the strength of the wealth effect versus the expectation effect.2

Since exchange rate volatility could cause the wealth effect or expectation effect to be uncertain, exchange rate volatility is certainly a variable that could have a direct impact on money demand. Mcgibany and Nourzad (1995) have already recognized the importance of exchange rate volatility in the demand for money specification by estimating a money demand function for the U.S. over the period of 1974-1990. As they argued, exchange rate volatility induces investors to substitute safer assets for riskier currency. They find that exchange rate volatility has a negative impact on M2 money demand in the U.S.

The main objective of this paper is to extend the literature related to the effects of exchange rate volatility on the demand for money by considering the experiences of as many less developed countries (LDCs) as data permits. The impact of exchange rate volatility on the money demand in LDCs is as relevant as it is in developed countries. Although the public in LDCs may not have good access to foreign assets, because of the black market for foreign exchange in many of these countries, they do speculate in holding domestic currency versus foreign currency.3 The volatility of the exchange rate can induce portfolio adjustment in favor of or against foreign currency depending on expectations, leaving the impact of exchange rate volatility on the demand for domestic currency to be ambiguous. The rest of the paper is organized as follows: Section 2 introduces the model and the methodology. Section 3 presents empirical support showing that indeed, exchange rate volatility has short-run as well as long-run effects on the demand for M2 monetary aggregate in LDCs. Section 3 provides a summary. Lastly, in the Appendix, data sources and the definitions of variables are listed.

2 The model and the method

Throughout the literature, the money demand function includes a scale variable measured by income, an opportunity cost variable that is measured by the interest rate, and the exchange rate, which accounts for currency substitution. …

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