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Are Price Equations Really Money Demand Equations on their Heads?

  • James G. MacKinnon
  • Ross D. Milbourne

It is often argued that the dependent variable in money demand functions is really the price level, the money stock itself being exogenous. A recent approach which stresses the theme is the "buffer stock" hypothesis, in which money supply shocks explicitly appear in the demand for money function, because prices and interest rates do not adjust rapidly enough to bring about short-run equilibrium in the money market. Although this approach has been adopted by a number of authors, it is not been subjected to much econometric testing. In this paper, we outline the economic and econometric issues involved in testing the exogenous money/buffer stock hypothesis, and subject it to a variety of tests using three different data sets. None of our results supports the hypothesis. Fundamental restrictions are rejected at very high levels of significance, and a reasonably good money demand equation is seen to be badly misspecified if interpreted as a price equation.

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Paper provided by Queen's University, Department of Economics in its series Working Papers with number 646.

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Length: 31 pages
Date of creation: 1986
Date of revision:
Publication status: Published in Journal of Applied Econometrics, 3, 1988
Handle: RePEc:qed:wpaper:646
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