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Exchange rate volatility and demand for money in less developed countries

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Abstract

One implication of currency substitution is that the exchange rate could serve as another determinant of the demand for money. Indeed, many studies have justified this empirically for the majority of countries. If the exchange rate serves as a determinant of the demand for money, exchange rate volatility could also influence money demand. By using annual data from 15 less developed countries and the bounds testing approach, we show that exchange rate volatility has short-run effects on the demand for real M2 monetary aggregate in LDCs. However, in most countries, short-run effects are not sustained.

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Notes

  1. For additional literature on this topic see Holden et al. (1979), Tower and Willett (1976), Al-Khuri and Nsouli (1978), Chaisrisawatsuk et al. (2004), Cuddington (1983), Bergstrand and Bundt (1990), and Leventakis (1993).

  2. Other studies that have included the exchange rate in the money demand function include Marquez (1987), McNown and Wallace (1992), and Bahmani (2008).

  3. For a comprehensive review of black markets and related issues see Agenor (1992).

  4. Note that if the dependent variable was demand for nominal balances, then an estimate of c could be positive. The only condition under which an estimate of c could be positive when we estimate the demand for real money is if the public has money illusion, i.e., they increase their nominal holdings at a rate higher than inflation rate. For more on money illusion see Alexander (1952, p. 273).

  5. In any macro model the likelihood of some variables being endogenous is high. The Autoregressive Distributed Lags approach adopted in this paper accounts for this by assuming all the lagged values to serve as instruments (Bahmani-Oskooee and Hajilee 2010, p. 650). Pesaran et al. (2001, p. 299) alert us to this issue by writing “our approach is quiet general in the sense that we can use a flexible choice for the dynamic lag structure in …..as well as allowing for short-run feedbacks.” Furthermore, the weighted average of the past inflation rates included in the short-run component of the model could be assumed to serve as a proxy for the expected inflation rate.

  6. Hafer and Kutan (1994) also found an income elasticity of greater than one for China and argued that it could be due to monetization of China under reform.

  7. We also tested for the stability of the coefficients after excluding the variability measure of the exchange rate. Only in the case of Belize was there evidence of instability. Thus, in this case, to have a stable money demand it is necessary to include the variability of the exchange rate.

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Authors and Affiliations

  1. University of Wisconsin at Milwaukee, Milwaukee, WI, 53201, USA

    Sahar Bahmani

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  1. Sahar Bahmani
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Correspondence to Sahar Bahmani.

Additional information

Thanks are due to two anonymous referees. Any error, however, is mine.

Appendix

Appendix

All data are annual over the period 1980–2009 and collected from International Financial Statistics of the IMF (on line).

Variables:

  • Real Money (M2): Nominal monetary aggregate (M1) is added to quazi money to get nominal M2. Nominal M2 is then deflated by GDP deflator (if not available by CPI) to obtain real M2.

  • Real Income (Y): In the absence of real GDP data, nominal GDP is deflated by GDP deflator (if not available, by CPI) to get real GDP.

  • Ln (P t /P t−1 ): CPI-based rate of inflation.

  • EX:The exchange rate, defined as nominal effective exchange rate. As such, a decrease reflects a depreciation of domestic currency. Nominal effective exchange rate is constructed as an index and is defined as weighted average of index of bilateral exchange rates between currency of a country and currencies of its major trading partners. Usually trade shares are used as weights.

  • V: Volatility measure of the exchange rate. Following previous research, e.g., De Vita and Abbott (2004), for each year, this variable is defined as standard deviation of the 12 monthly real effective exchange rate within that year.

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Bahmani, S. Exchange rate volatility and demand for money in less developed countries. J Econ Finan 37, 442–452 (2013). https://doi.org/10.1007/s12197-011-9190-y

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