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money_demand - IMF WORKING PAPER 1991 International...

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© 1991 International Monetary Fund This is a working paper and the author would welcome any comments on the present text. Citations should refer to an unpublished manuscript, mentioning the author and the date of issuance hy the International Monetary Fund. The views expressed are those of the author and do not neces- sarily represent those of the Fund. IMF WORKING PAPER HP!91!45 INTERNATIONAL MONETARY FUND Research Department The Demand for Money in Developing Countries: Assessing the Role of Financial Innovation Prepared by Patricio Arrau*, Jose De Gregorio,** Carmen Reinhart,** and Peter Wickham** May, 1991 Abstract Traditional specifications of money demand have been commonly plagU4:!d by persistent overprediction, implausible parameter estimates, and highly autocorrelated errors. This paper argues that some of those problems stem from the failure to account for the impact of financial innovation. We estimate money demand for ten developing countries employing various proxies for the innovation process and provide an assessment of the relative importance of this variable. We find that financial innovation plays an important role in determining money demand and its fluctuations, and that the importance of this role increases with the rate of inflation. JEL Classification Numbers: E4l, E44 * World Bank ** Internat:ionalMonetary Fund. The authors would like to thank Greg Hess for valuable comments.
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- ii - Contents I. Introduction 1 II. Theoretical Framework 1. Households' demand for money 2. Firms' demand for money: A transactions cost model 3. Aggregation issues 4. The opportunity cost of money 2 3 4 6 6 III. Failure of Traditional Approaches 1. Data and specification issues 2. Empirical results 8 9 9 IV. The Extended Model: Alternative Approaches to Modeling Financial Innovation 1. Is a deterministic trend a good proxy for financial innovation? 2. Is a stochastic trend a good proxy for financial innovation? 3. Is the role of financial innovation large or small? 10 12 15 18 V. Concluding Remarks 23 Appendices I. Discussion on Aggregation and the Regression Error II. Estimation with a Time-Varying Intercept 25 28 References 30 Text Tables 1. 2. 3. 4. 5. Traditional Money Demand Specification A Deterministic Trend as a Proxy for Financial Innovation A Stochastic Process as a Proxy for Financial Innovation Most "Plausible" Specification How Much of the Explained variation is Accounted by Financial Innovation 11 13 17 19 22 Appendix Tables 1. 2. Data Set M2/Ml as a Proxy for Financial Innovation 27 27 Figures 1. GAMMA 20a 2. Share of Financial Innovation 20a 3. Share of Financial Innovation (Time-Varying Intercept Equation) 24a
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- iii - Summary Traditional specifications of money demand have been commonly plagued by persistent overprediction, implausible parameter estimates, and highly autocorrelated errors. This paper argues that some of those problems stem from failure to account for the impact of financial innova- tion. The empirical part of the paper finds that financial innovation is an important determinant of money demand and its fluctuations and that this importance increases with the rate of inflation.
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