Revisiting the Role of the Money Demand Function: Does the Shortfall in Money Demand Impact the Inflation Responses to the Exchange Rate Depreciation Shocks?

Does the excess or shortfall in money demand affect the transmission of the rand exchange rate depreciation shocks to inflation? If so, does this depend on whether the money demand function includes or excludes wealth variables? The results show that the extension of the money demand functions via the wealth channel and portfolio-balance approaches is supported by the data. The estimated income elasticities are lower in models with financial variables in comparison to that estimated under the conventional money demand function. Furthermore, the inclusion of wealth variables results in a slow speed of adjustment from disequilibrium. Evidence from the counterfactual analysis shows that the money demand shortfall shock dampens the pass-through of the rand exchange rate deprecation shocks to inflation. The results imply that the nature of the disequilibrium in the money demand function from models augmented with financial variable conveys valuable information for price and financial stability objectives. From the interaction of monetary policy and financial stability perspective this means that the extension of the money demand function can capture aspects related to asset price inflation and wealth channels of the transmission mechanism.