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Interest rate sensitivity of demand for money and effectiveness of monetary policy: fresh evidence from combined cointegration test and ARDL approach

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Abstract

The money demand function (MDF) is an inevitable monetary policy tool utilized to examine the impact of the monetary sector on the real sector. However, financial innovation and institutional changes in the late 1970s and early 80s have affected the money demand stability. Henceforth, less importance has been given to money in the new Keynesian monetary policy framework. In the preceding backdrop, the present study examines money demand stability by highlighting the interest rates sensitivity as an inevitable issue while estimating different monetary aggregates. To this end, we utilize the combined cointegration, autoregressive distributed lag model, and Hansen’s instability test. The study finds cointegration among variables under consideration and a well-specified MDF, implying a stable short-and long-run money demand relationship in India for the period 1996:Q2 to 2016:Q3. Henceforth, the stable money demand has policy implications in terms of focusing monetary aggregate as an essential indicator or information variable to maintain the price stability under India’s current flexible inflation-targeting framework.

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Notes

  1. For a detailed explanation of financial innovation (see Lewis and Mizen 2000) and its impact on MDF, see Adil et al. (2020a).

  2. After the financial crisis of 2007–2008, leading central banks worldwide implemented forward guidance, a tool used vastly for the future course of the monetary policy. The famous speech of Draghi "Whatever it takes", followed by the announcement of Outright Monetary Transactions in 2012, was never applied. However, the programme alleviated the tensions in the euro area. ECB Website, Press Release, Technical features of Outright Monetary Transactions https://www.ecb.europa.eu/press/pr/date/2012/html/pr120906_1.en.html (Accessed in October 27, 2020).

  3. For detailed discussion over different monetary policy regimes in India, see Adil and Rajadhyaksha (2021).

  4. Mishikin and Serletis (2011, p. 563) states, “The theory of asset demand indicates that the demand for money should be a function of the resources available to individuals (their wealth) and the expected returns on other assets relative to the expected return on money.

  5. For the detailed discussion over wealth and currency substitution effect see, Arango and Nadiri (1981) and Adil et al. (2020b).

  6. The advantages can be found in the studies by Pesaran et al. (2001)

  7. For further application of ARDL model, see, inter alia, Hamid et al. (2022), Mujtaba et al. (2020), Mujtaba and Jena (2021) and Mujtaba et al. (2021).

  8. The rationale behind utilizing the longer-term interest rate while estimating LnM3 is the aggregation of M3. The components of M3 is more inclined towards longer duration interest rates. Hence, estimating M3 with short-term interest rate may lead to model mis-specification, in turn, we may get unstable MDF.

  9. For detailed discussion over money through new Keynesian and new monetarist perspective, see Adil et al. (2021).

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Authors and Affiliations

  1. Humanities and Social Sciences, Indian Institute of Technology (IIT), Palakkad, Kerala, 678623, India

    Masudul Hasan Adil

  2. Department of Economics, Sultan-ul-Uloom Educational Society (SUES), Hyderabad, India

    Rafiq Hussain

  3. Department of Agricultural and Food Science, University of Bologna, Bologna, Italy

    Adelajda Matuka

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  1. Masudul Hasan Adil
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Adil, M.H., Hussain, R. & Matuka, A. Interest rate sensitivity of demand for money and effectiveness of monetary policy: fresh evidence from combined cointegration test and ARDL approach. SN Bus Econ 2, 65 (2022). https://doi.org/10.1007/s43546-022-00249-8

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