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Financial innovation and money demand : theory and empirical implementation

  • Arrau, Patricio
  • de Gregorio, Jose

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.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 585.

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Date of creation: 01 Jan 1991
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Handle: RePEc:wbk:wbrwps:585
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  1. Baumol, William J & Tobin, James, 1989. "The Optimal Cash Balance Proposition: Maurice Allais' Priority," Journal of Economic Literature, American Economic Association, vol. 27(3), pages 1160-62, September.
  2. Svensson, Lars E O, 1985. "Money and Asset Prices in a Cash-in-Advance Economy," Journal of Political Economy, University of Chicago Press, vol. 93(5), pages 919-44, October.
  3. Perron, Pierre, 1989. "The Great Crash, the Oil Price Shock, and the Unit Root Hypothesis," Econometrica, Econometric Society, vol. 57(6), pages 1361-1401, November.
  4. Marquez, Jaime, 1987. "Money demand in open economies: A currency substitution model for Venezuela," Journal of International Money and Finance, Elsevier, vol. 6(2), pages 167-178, June.
  5. Mankiw, N Gregory & Summers, Lawrence H, 1986. "Money Demand and the Effects of Fiscal Policies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 18(4), pages 415-29, November.
  6. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
  7. Carlos A. Végh, 1989. "Government Spending and Inflationary Finance: A Public Finance Approach," IMF Staff Papers, Palgrave Macmillan, vol. 36(3), pages 657-677, September.
  8. Bennett T. McCallum, 1982. "The Role of Overlapping-Generations Models in Monetary Economics," NBER Working Papers 0989, National Bureau of Economic Research, Inc.
  9. Engle, Robert F. & Yoo, Byung Sam, 1987. "Forecasting and testing in co-integrated systems," Journal of Econometrics, Elsevier, vol. 35(1), pages 143-159, May.
  10. Jose De Gregorio, 1991. "Welfare Costs of Inflation, Seigniorage, and Financial innovation," IMF Working Papers 91/1, International Monetary Fund.
  11. Goldfeld, Stephen M. & Sichel, Daniel E., 1990. "The demand for money," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 1, chapter 8, pages 299-356 Elsevier.
  12. Arrau, Patricio, 1990. "Intertemporal substitution in a monetary framework : evidence from Chile and Mexico," Policy Research Working Paper Series 549, The World Bank.
  13. Dornbusch, Rudiger & Mussa, Michael, 1975. "Consumption, Real Balances and the Hoarding Function," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 16(2), pages 415-21, June.
  14. Englund, Peter, 1989. "Monetary Policy and Bank Regulations in an Economy with Financial Innovations," Economica, London School of Economics and Political Science, vol. 56(224), pages 459-72, November.
  15. Cooley, Thomas F & Prescott, Edward C, 1976. "Estimation in the Presence of Stochastic Parameter Variation," Econometrica, Econometric Society, vol. 44(1), pages 167-84, January.
  16. Englund, Peter & Svensson, Lars E O, 1988. "Money and Banking in a Cash-in-Advance Economy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 29(4), pages 681-705, November.
  17. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  18. Cooley, Thomas F & Prescott, Edward C, 1973. "An Adaptive Regression Model," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 14(2), pages 364-71, June.
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  20. Johansen, Soren & Juselius, Katarina, 1990. "Maximum Likelihood Estimation and Inference on Cointegration--With Applications to the Demand for Money," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 52(2), pages 169-210, May.
  21. Feenstra, Robert C., 1986. "Functional equivalence between liquidity costs and the utility of money," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 271-291, March.
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