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The Short-Run Demand for Money: A Reconsideration

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  • Gordon, Robert J

Abstract

The partial-adjustment approach to the specification of the short-run demand for money has dominated the literature for more than a decade. There are three basic problems with this approach. First, the same lag structure is imposed on all variables, and such independent variables enters only as a current value. In contrast a rational individual would respond to different variables (income, interest rates, prices) with quite different lags. Second, when the general price level is subject to gradual adjustment but can move quickly in response to supply shocks, the influence of these supply shocks should enter with a negative sign. Third, the estimated equation for real balances may not be a money demand equation at all, but rather its coefficients may represent a shifting mixture of demand and supply responses. The empirical work examines several alternative dynamic specifications, including a generalized partial adjustment framework and the error-correction model. Both of the latter specifications exhibit greater structural stability after 1973 than the standard partial adjustment model, and the generalized partial adjustment model also yields relatively small errors in post-sample dynamic simulations. Shifts in coefficients as the sample period is extended after 1973 are consistent with the interpretation that the real balance equation no longer traces out structural demand parameters, but rather a mixture of demand and supply responses.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 24.

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Date of creation: Jul 1984
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Handle: RePEc:cpr:ceprdp:24

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Keywords: Error-Correction Models; Money Demand; Partial Adjustment Model; Real Balance Equation;

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References

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  1. Milton Friedman, 1959. "The Demand for Money: Some Theoretical and Empirical Results," Journal of Political Economy, University of Chicago Press, vol. 67, pages 327.
  2. Rose, Andrew K, 1985. "An Alternative Approach to the American Demand for Money," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 17(4), pages 439-55, November.
  3. Robert J. Barro, 1976. "Unanticipated Money Growth and Unemployment in the United States," Working Papers 234, Queen's University, Department of Economics.
  4. Granger, C. W. J. & Newbold, P., 1974. "Spurious regressions in econometrics," Journal of Econometrics, Elsevier, vol. 2(2), pages 111-120, July.
  5. Coats, Warren L, Jr, 1982. "Modeling the Short-Run Demand for Money with Exogenous Supply," Economic Inquiry, Western Economic Association International, vol. 20(2), pages 222-39, April.
  6. Gordon, Robert J, 1981. "Output Fluctuations and Gradual Price Adjustment," Journal of Economic Literature, American Economic Association, vol. 19(2), pages 493-530, June.
  7. Cooley, Thomas F & LeRoy, Stephen F, 1981. "Identification and Estimation of Money Demand," American Economic Review, American Economic Association, vol. 71(5), pages 825-44, December.
  8. Meade, James E, 1978. "The Meaning of "Internal Balance"," Economic Journal, Royal Economic Society, vol. 88(351), pages 423-35, September.
  9. Plosser, Charles I. & Schwert*, G. William, 1978. "Money, income, and sunspots: Measuring economic relationships and the effects of differencing," Journal of Monetary Economics, Elsevier, vol. 4(4), pages 637-660, November.
  10. Bean, Charles R, 1983. "Targeting Nominal Income: An Appraisal," Economic Journal, Royal Economic Society, vol. 93(372), pages 806-19, December.
  11. Brunner, Karl & Meltzer, Allan H., 1980. "On the state of macroeconomics," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 12(1), pages 1-5, January.
  12. Robert E. Hall, 1983. "Macroeconomic policy under structural change," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 85-122.
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Citations

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Cited by:
  1. Ricardo J. Caballero & Eduardo M.R.A. Engel, 1992. "Microeconomic Rigidities and Aggregate Price Dynamics," NBER Working Papers 4162, National Bureau of Economic Research, Inc.
  2. Schmidt, Martin B., 2001. "The long and short of money and prices: a market equilibrium approach," Journal of Economics and Business, Elsevier, vol. 53(6), pages 563-583.
  3. Cheong, ChongCheul, 2003. "Regime changes and econometric modeling of the demand for money in Korea," Economic Modelling, Elsevier, vol. 20(3), pages 437-453, May.
  4. Hendry, David F. & Ericsson, Neil R., 1991. "Modeling the demand for narrow money in the United Kingdom and the United States," European Economic Review, Elsevier, vol. 35(4), pages 833-881, May.
  5. Arnold, Ivo J. M., 1996. "Stochastic trends in the long-run behavior of velocity: A new test of the institutional hypothesis," Journal of Policy Modeling, Elsevier, vol. 18(6), pages 623-641, December.
  6. Martin Schmidt, 2003. "Money and prices: evidence from the G7 countries," Applied Economics, Taylor & Francis Journals, vol. 35(17), pages 1799-1809.
  7. Daniel L. Thornton, 1985. "Money demand dynamics: some new evidence," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 14-23.
  8. Martin Schmidt, 2003. "Monetary dynamics: a market approach," Applied Economics, Taylor & Francis Journals, vol. 35(2), pages 139-152.
  9. Tin, Jan, 1999. "Short-run and long-run demand for financial assets A microeconomic perspective," International Review of Economics & Finance, Elsevier, vol. 8(4), pages 467-478, November.
  10. Grech, Aaron George, 2014. "The demand for currency in Malta," MPRA Paper 53878, University Library of Munich, Germany.
  11. Issing, Otmar, 1997. "Monetary targeting in Germany: The stability of monetary policy and of the monetary system," Journal of Monetary Economics, Elsevier, vol. 39(1), pages 67-79, June.
  12. Erwin W. Heri, 1988. "Money Demand Regressions and Monetary Targeting Theory and Stylized Evidence," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 124(II), pages 123-149, June.
  13. Martin B. Schmidt, 2004. "Exogeneity within the M2 Demand Function: Evidence from a Large Macroeconomic System," Economic Inquiry, Western Economic Association International, vol. 42(4), pages 634-646, October.
  14. Yu Hsing, 2007. "Currency Substitution, Capital Mobility and Functional Forms of Money Demand in Pakistan," Lahore Journal of Economics, Department of Economics, The Lahore School of Economics, vol. 12(1), pages 35-48, Jan-Jun.
  15. Darrat, Ali F. & Al-Mutawa, Ahmed, 1996. "Modelling money demand in the United Arab Emirates," The Quarterly Review of Economics and Finance, Elsevier, vol. 36(1), pages 65-87.
  16. Martin Schmidt, 2007. "The long and short of money: short-run dynamics within a structural model," Applied Economics, Taylor & Francis Journals, vol. 40(2), pages 175-192.
  17. Tin, Jan, 1999. "The impacts of racial differences on demand for financial assets," International Review of Financial Analysis, Elsevier, vol. 8(3), pages 269-282, March.
  18. A. M. M. Jamal & Yu Hsing, 2011. "The Demand for Money in a Simultaneous-Equation Framework," Economics Bulletin, AccessEcon, vol. 31(2), pages 1929-1934.

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