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Money Demand in the euro area, the US and the UK:Assessing the Role of Nonlinearity

This paper estimates money demand equations for the euro area, the US and the UK using three different econometric methodologies: (i) a linear model based on a dynamic ordinary least squares (DOLS); (ii) a nonlinear technique based on a quantile regression framework; and (iii) a nonlinear model relying on a smooth-transition regression. The linear model shows that the elasticity of money demand with respect to income is positive and large in magnitude, while the elasticity of money demand with respect to the interest rate is negative and generally small. The quantile regression technique highlights that: (i) the income and the interest rate semi-elasticities are significantly different from the OLS estimates at the tails of the distribution of real money holdings; and (ii) the sensitivity of money demand with respect to inflation tends to be larger when real money holdings are extremely low. Finally, the smooth transition model provides two interesting findings. On the one hand, they capture reasonably well the dynamics of the money demand function. On the other hand, they show that the elasticity of money demand with respect to inflation rate, interest rate and GDP varies not only in accordance with the regime considered, but also across the countries under consideration.

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Paper provided by NIPE - Universidade do Minho in its series NIPE Working Papers with number 22/2012.

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Date of creation: 2012
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Handle: RePEc:nip:nipewp:22/2012
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  1. Michael Funke, 2001. "Money Demand in Euroland," Quantitative Macroeconomics Working Papers 20112, Hamburg University, Department of Economics.
  2. Stephen Hall & P.A.V.B. Swamy & George S. Tavlas, 2012. "Milton Friedman, the Demand for Money and the ECB’s Monetary-Policy Strategy," Discussion Papers in Economics 12/05, Department of Economics, University of Leicester.
  3. Barnett, William A. & Chauvet, Marcelle, 2010. "How better monetary statistics could have signaled the financial crisis," MPRA Paper 24721, University Library of Munich, Germany.
  4. Barnett, William A. & Chauvet, Marcelle & Tierney, Heather L. R., 2007. "Measurement Error in Monetary Aggregates: A Markov Switching Factor Approach," MPRA Paper 10150, University Library of Munich, Germany, revised 06 Aug 2008.
  5. Roberto Golinelli & Sergio Pastorello, 2002. "Modelling the demand for M3 in the Euro area," The European Journal of Finance, Taylor & Francis Journals, vol. 8(4), pages 371-401.
  6. Georges Prat & Fredj Jawadi, 2007. "Nonlinear stock prices adjustment in the G7 countries," Working Papers halshs-00172896, HAL.
  7. Peter N. Ireland, 2007. "On the Welfare Cost of Inflation and the Recent Behavior of Money Demand," Boston College Working Papers in Economics 662, Boston College Department of Economics.
  8. Stephen Hall & George Hondroyiannis & P.A.V.B. Swamy & George S. Tavlas, 2009. "Assessing the Casual Relationship between Euro-Area Money and Price in Time-Varying Environment," Discussion Papers in Economics 09/17, Department of Economics, University of Leicester.
  9. van Dijk, Dick & Teräsvirta, Timo & Franses, Philip Hans, 2000. "Smooth Transition Autoregressive Models - A Survey of Recent Developments," SSE/EFI Working Paper Series in Economics and Finance 380, Stockholm School of Economics, revised 17 Jan 2001.
  10. Lutkepohl, Helmut & Terasvirta, Timo & Wolters, Jurgen, 1999. "Investigating Stability and Linearity of a German M1 Money Demand Function," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 14(5), pages 511-25, Sept.-Oct.
  11. Stephen G.Hall & George Hondroyiannis & P.A.V.B. Swamy & George S. Tavlas, 2007. "A Portofolio Balance Approach to Euro-Area Money Demand in a Time-Varying Environment," Working Papers 61, Bank of Greece.
  12. Barnett, William A, 1983. "New Indices of Money Supply and the Flexible Laurent Demand System," Journal of Business & Economic Statistics, American Statistical Association, vol. 1(1), pages 7-23, January.
  13. Stephen M. Goldfeld, 1973. "The Demand for Money Revisited," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 4(3), pages 577-646.
  14. Chrystal, K Alec & Mizen, Paul, 2005. "A Dynamic Model of Money, Credit, and Consumption: A Joint Model for the UK Household Sector," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(1), pages 119-43, February.
  15. Rafiq, M.S. & Mallick, S.K., 2008. "The effect of monetary policy on output in EMU3: A sign restriction approach," Journal of Macroeconomics, Elsevier, vol. 30(4), pages 1756-1791, December.
  16. Koenker,Roger, 2005. "Quantile Regression," Cambridge Books, Cambridge University Press, number 9780521608275.
  17. Koenker, Roger W & Bassett, Gilbert, Jr, 1978. "Regression Quantiles," Econometrica, Econometric Society, vol. 46(1), pages 33-50, January.
  18. Granville, Brigitte & Mallick, Sushanta, 2009. "Monetary and financial stability in the euro area: Pro-cyclicality versus trade-off," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 19(4), pages 662-674, October.
  19. Sushanta Mallick & Mohammed Mohsin, 2010. "On the real effects of inflation in open economies: theory and empirics," Empirical Economics, Springer, vol. 39(3), pages 643-673, December.
  20. Fredj Jawadi & Ricardo M. Sousa, 2013. "Modelling money demand: further evidence from an international comparison," Applied Economics Letters, Taylor & Francis Journals, vol. 20(11), pages 1052-1055, July.
  21. K. Alec Chrystal & Paul Mizen, 2005. "Other financial corporations: Cinderella or ugly sister of empirical monetary economics?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 10(1), pages 63-80.
  22. Sousa, Ricardo M., 2010. "Housing wealth, financial wealth, money demand and policy rule: Evidence from the euro area," The North American Journal of Economics and Finance, Elsevier, vol. 21(1), pages 88-105, March.
  23. Roger Koenker & Zhijie Xiao, 2002. "Inference on the Quantile Regression Process," Econometrica, Econometric Society, vol. 70(4), pages 1583-1612, July.
  24. Hall, Stephen G. & Hondroyiannis, George & Swamy, P.A.V.B. & Tavlas, George S., 2009. "Assessing the causal relationship between euro-area money and prices in a time-varying environment," Economic Modelling, Elsevier, vol. 26(4), pages 760-766, July.
  25. Salam K. Fayyad, 1986. "A microeconomic system-wide approach to the estimation of the demand for money," Review, Federal Reserve Bank of St. Louis, issue Aug, pages 22-33.
  26. Timo Teräsvirta & Ann-Charlotte Eliasson, 2001. "Non-linear error correction and the UK demand for broad money, 1878-1993," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 16(3), pages 277-288.
  27. Jawadi, Fredj, 2012. "Introduction To Time-Varying Modeling With Macroeconomic And Financial Data," Macroeconomic Dynamics, Cambridge University Press, vol. 16(S2), pages 167-175, September.
  28. Arouri, Mohamed El Hedi & Jawadi, Fredj & Nguyen, Duc Khuong, 2012. "Modeling Nonlinear And Heterogeneous Dynamic Links In International Monetary Markets," Macroeconomic Dynamics, Cambridge University Press, vol. 16(S2), pages 232-251, September.
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