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Demand for Money in Transition: Evidence from China’s Disinflation

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We examine money demand in the Chinese economy during a period characterized by significant disinflation and outright deflation, coupled with strong output growth. Our study establishes a stable money demand system for broad money M2. Inflation affects the adjustment of the system towards equilibrium, and shocks to broad money are found to lead to higher inflation in the context of an impulse response analysis. No evidence of non-linearity in money demand is found for the disinflationary period. The results provide support for the People’s Bank of China’s policy of specifying intermediate targets for money growth. Importantly, our results suggest that movements in the nominal effective exchange rate should be taken into account in a successful implementation of such a policy.

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Fig. 2


  1. 1.

    The consumer price index is constructed by using month-on-month growth rates for 2003 and year-on-year growth rates otherwise. The quarterly series is an average of monthly values. GDP deflator is not available for China on a quarterly basis.

  2. 2.

    Real output is obtained by deflating the quarterly nominal GDP by the consumer price index from 1995 onwards. The observations for 1994 are obtained by using annual growth rates, as no quarterly level data is available.

  3. 3.

    The effective exchange rate in levels has been used in money demand studies by McNown and Wallace (1992), Bahmani-Oskooee et al. (1998), Bahmani-Oskooee and Pourheydarian (1990), among others.

  4. 4.

    We do not restrict a trend in the cointegration relation, following the argument by Brüggemann and Lütkepohl (2006) that it is difficult to theoretically motivate the inclusion of such a deterministic variable in a money demand relation.

  5. 5.

    Specifically, the adjusted Portmanteau test statistic to detect autocorrelation in the model residuals, utilizing 16 lags, amounts to 223.12 (with a p-value of 0.50). The Breusch-Godfrey test for autocorrelation in lower lag orders yields an LM-test statistic of 89.52 (p-value 0.22) at five lags, while at four lags the statistic obtains a value of 70.31 (p-value 0.27) and at one lag 17.20 (p-value 0.37). The Jarque-Bera test for nonnormality in the four individual equations of the model yield test statistics of 0.75, 1.44, 3.02, 1.63, respectively (with the corresponding p-values 0.69, 0.49, 0.22 and 0.44). Finally, ARCH-LM tests for possible ARCH-effects in the model residuals, conducted at 16 lags for each of the four equations, yield test statistics of 15.64, 7.40, 8.00 and 12.79 (with the corresponding p-values 0.48, 0.96, 0.95 and 0.69).


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I would like to thank Stephen G. Cecchetti, Chia-Liang Hung, Tuuli Koivu, Iikka Korhonen, Reinhard Neck, Jouko Rautava, Pekka Sutela, Yulia Vymyatnina, Yan Zhang, seminar participants at the Bank of Finland, the 61st IAES Conference and the BOFIT/CEFIR Workshop on Transition Economics for fruitful discussions and comments. All the mistakes are my own. All opinions expressed are those of the author and do not necessarily reflect the views of the Bank of Finland.

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Correspondence to Aaron N. Mehrotra.

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Mehrotra, A.N. Demand for Money in Transition: Evidence from China’s Disinflation. Int Adv Econ Res 14, 36–47 (2008).

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  • Money demand
  • Disinflation
  • Deflation
  • China


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