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Empirical Assessment of Money Demand Stability Under India’s Open Economy: Non-linear ARDL Approach

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What we need is not a skilled monetary driver of the economic vehicle continuously turning the steering wheel to adjust to the unexpected irregularities of the route, but some means of keeping the monetary passenger who is in the back seat as ballast from occasionally leaning over and giving the steering wheel a jerk that threatens to send the car off the road.

— Milton Friedman

Abstract

This study explores stability issues of money demand in the wake of a new economic policy regime of India’s open economy, particularly since the 1990s. The study covers dataset on quarterly frequency from 1996: Q2 to 2016: Q3. In this paper, it is shown that the failure to find a significant relationship between exchange rate and the demand for money—more specifically stable money demand, could be due to the supposition of symmetric adjustment mechanism among variables. Importantly, the asymmetry is introduced in money demand function through partial sum decomposition in the autoregressive distributed lag model. It is found that exchange rate appreciation or depreciation affects the money demand in an asymmetric fashion. Ultimately, the study finds stable money demand in case of India. Further, the exchange rate affects money demand through currency substitution effect; provided the dataset, variables and econometric techniques under study.

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Notes

  1. Present study utilises NEER as a proxy for exchange rate rather than the REER. The rationale behind using NEER is as follows, since REER is inflation adjusted while NEER is inflation unadjusted. Importantly, earlier study (for instance Bhardwaj and Pandit 2010) has taken inflation as one of the explanatory variable in the estimation of MDF. Here, the component of inflation is reflected in NEER rather than REER. Therefore, it is postulated to keep NEER as an explanatory variable in the estimation of MDF in order to get more robust result.

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Acknowledgements

This research paper is a part of work done in the Indira Gandhi Institute of Development Research (IGIDR) under the Visiting Scholar Programme (VSP), 2017. I thank committee members of VSP for their valuable comments and suggestion. Specifically, I thank Prof. Rajendra Vaidya and Prof. Ashima Goyal for their suggestions in the empirical analysis and Prof. R. Krishnan for the discussion over my doubts. The usual disclaimer applies.

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Authors and Affiliations

  1. Mumbai School of Economics and Public- Policy (Autonomous), University of Mumbai, Mumbai, 400098, India

    Masudul Hasan Adil & Neeraj R. Hatekar

  2. School of Economics, University of Hyderabad, Hyderabad, 500046, India

    Salman Haider

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  1. Masudul Hasan Adil
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Correspondence to Masudul Hasan Adil.

Appendix: Variables’ Description

Appendix: Variables’ Description

In this appendix, we discuss the details about the construction of the variables used in this study.

Real Broad Money (M3) Nominal monetary aggregate (M3) is defined as the addition of the time deposits into narrow money definition; where narrow money is defined as the addition of currency with the public, other’s deposits with the RBI and demand deposits. Finally, nominal broad money is deflated by WPI to obtain real broad money (M3).

Real Income (Y) Gross Domestic Product (GDP) at market prices (at constant prices, base year: 2004–2005) is taken as a proxy for real income. Real income represents a scale variable in MDF.

Interest Rate (R) To have a better estimation of broad money, the study utilises 364 day Treasury bill rate (TB-364). Obviously, it is a long term interest rate as compared to the call money rate (CMR). Since it is evident that by construction broad money deals with the long term interest rate hence we use here TB-364.

Exchange Rate (EX) Study takes the nominal effective exchange rate (NEER) as a proxy for the exchange rate. NEER is taken for 36 currency Trade Based Weight (the base year 2004–2005).

Stock Prices (ln SP) Stock prices are important financial series, which helps to represent the macroeconomic scenario of any country. Several studies have considered stock market prices to investigate its effect on money demand in emerging economies (for instance Mwanzia et al. 2017 in case of Kenya; Hye et al. 2009 in case of Pakistan). Therefore, the study incorporates stock prices in MDF in case of India. Here, closing values of Sensex is considered a proxy for stock prices.

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Adil, M.H., Haider, S. & Hatekar, N.R. Empirical Assessment of Money Demand Stability Under India’s Open Economy: Non-linear ARDL Approach. J. Quant. Econ. 18, 891–909 (2020). https://doi.org/10.1007/s40953-020-00203-1

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