In Search of a Stable, Short-Run M1 Demand Function
Mehra, Yash P., Economic Review
Conventional(1) M1 demand equations went off track at least twice during the 1980s, failing to predict either the large decline in M1 velocity in 1982-83 or the explosive growth in M1 in 1985-86. A number of-hypotheses were advanced to explain the prediction errors, but none of these were completely Satisfactory.(2) As a result, several analysts have concluded that there has been a fundamental change in the character of M1 demand.
In recent years, some economists have sought to fix conventional M1 demand functions by focusing on specifications that pay adequate attention to the long-run nature and short-run dynamics of money demand. As is well known, conventional money demand functions have been estimated using data either in levels or in differences. Recent advances in time series analysis designed to deal with nonstationary data, however, have raised doubts about either specification. This has led several analysts to integrate these two specifications using cointegration(3) and error-correction techniques. In this approach, one first tests for the presence of a long-run, equilibrium (cointegrating) relationship between real money balances and its explanatory variables including real income and interest rates. If the test for cointegration indicates that such a relationship exists, an equilibrium regression is fit using the levels of the variables. The calculated residuals from the long-run money demand regression are then used in an error-correction model, which specifies the short-run behavior of money demand. This approach thus results in a money demand specification which could include both levels and differences of relevant explanatory variables.(4)
Those who have used cointegration techniques to test for the existence of a long-run, equilibrium M1 demand function, however, have found mixed results. For example, Baum and Furno (1990), Miller (1991), and Hafer and Jansen (1991) do not find a long-run equilibrium relationship between real M1, real income, and a short-term nominal interest rate. Other analysts including Hoffman and Rasche (1991), Dickey, Jansen and Thornton (1991), and Stock and Watson (1991), on the other hand, have presented evidence favorable to the presence of a long-run relationship among these variables.(5)
This study examines whether conventional M1 demand functions reformulated using error-correction techniques can explain the short-run behavior of M1. Much of the recent work on M1 demand has focused on the search for a long-run money demand function. In fact, those economists, who have found a long-run cointegrating relationship between real M1 and its explanatory variables (like real income and Interest rates), either have not constructed error-correction models of money demand or have constructed but failed to evaluate them for parameter stability and for explaining M1's short-run behavior.(6)
This study makes the basic assumption that there exists a long-run equilibrium relationship between real M1, real income, and an opportunity cost variable over the postwar period 1953Q1 to 1991Q2.(7) Under this assumption, error-correction models of M1 demand are constructed, tested for parameter stability, and evaluated for predictive ability. The empirical results indicate that these error-correction models do not depict parameter stability, nor do they adequately explain the short-run behavior of M1 in the 1970s and the 1980s. These results imply that the long-run M1 demand functions postulated here and in several recent M1 demand studies are misspecified. This has the policy implication that M1 remains unreliable as an indicator variable for monetary policy.
The plan of this study is as follows. Section I presents the basic error-correction model, reviews the Engle-Granger test of cointegration, and describes a simple procedure for estimating the error-correction model. Section II presents empirical results. Concluding observations are given in Section III.