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Financial innovation and money demand : theory and empirical implementation

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  • Arrau, Patricio
  • de Gregorio, Jose

Abstract

Empirically, traditional money demand equations are frequently characterized by periods of"missing money", unstable parameters, and autocorrelated errors. The common practice to solve these problems consists of changing the specification of the regressions once the shifts (which are usually associated to financial innovation) are identified. This paper provides an alternative approach to dealing with the unobservable process of financial innovation. It consists of modelling financial innovation as shocks that have permanent effects on the money demand, analogous to productivity shocks in production functions. This paper describes the theoretical model used and shows the failure of traditional money demand equations using cointegration techiques. It describes a simple GLS-iterative econometric model which allows the authors to recover the path of financial innnovation and obtain sensible estimates of the relevant elasticities. It also shows Monte Carlo simulations to evaluate the behavior of the estimation procedure for particular samples and data generating processes, and to study how robust the procedure to some deviations from the basic assumptions is.

Suggested Citation

  • Arrau, Patricio & de Gregorio, Jose, 1991. "Financial innovation and money demand : theory and empirical implementation," Policy Research Working Paper Series 585, The World Bank.
  • Handle: RePEc:wbk:wbrwps:585
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Javier Gómez P., 1998. "La Demanda Por Dinero En Colombia," BORRADORES DE ECONOMIA 002969, BANCO DE LA REPÚBLICA.
    2. Arrau, Patricio & De Gregorio, Jose & Reinhart, Carmen M. & Wickham, Peter, 1995. "The demand for money in developing countries: Assessing the role of financial innovation," Journal of Development Economics, Elsevier, vol. 46(2), pages 317-340, April.
    3. Calvo, Guillermo & Vegh, Carlos, 1992. "Currency Substitution in Developing Countries: An Introduction," MPRA Paper 20338, University Library of Munich, Germany.
    4. Easterly, William R & Mauro, Paolo & Schmidt-Hebbel, Klaus, 1995. "Money Demand and Seigniorage-Maximizing Inflation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(2), pages 583-603, May.
    5. Martner Fanta, Ricardo & Titelman Kardonsky, Daniel, 1992. "La demanda de dinero en Chile: una comparación de métodos alternativos de estimación de vectores de cointegración," Series Históricas 8, Naciones Unidas Comisión Económica para América Latina y el Caribe (CEPAL).
    6. James Boughton, 1992. "International comparisons of money demand," Open Economies Review, Springer, vol. 3(3), pages 323-343, October.

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