The Stabililty of Money Demand in Bangladesh: an Econometric Study Essay

CHAPTER-ONE 1 - The Stabililty of Money Demand in Bangladesh: an Econometric Study Essay introduction. Introduction: The money demand is one of the most closely studied relationships in economics. One reason is that the question of the stability of money demand has long been central to issues of monetary theory. However, despite intensive analytical and empirical efforts, there is no general consensus concerning the stability (or instability) of money demand. Existence of a stable money demand is very much important for maintaining monetary stability. Though there are lots of debates in this topic, it is a subject on which macroeconomists can do further research.

Many researchers have estimated money demand stability model for different economies in different points in time. To date, extensive theoretical and empirical research has been conducted in the search for the appropriate variables and functional forms of the stability of money demand both in the context of developed and developing economies. However, there have been a limited number of empirical studies that attempted to investigate the issue in the context of Bangladesh.

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These studies on the stability of money demand in Bangladesh suffer from flaws in terms of the: (i) adopted econometric estimation techniques; (ii) choice of appropriate variables; and (iii) data coverage, i. e. , the time span. Most of the tests have employed standard regression techniques (i. e. , ordinary least squares (OLS)) without examining the time series properties of the concerned macroeconomic variables. Since it is highly plausible that some of the time series variables that these studies have used are non-stationary in their levels, and therefore, the standard regression results are questionable.

Considering all these things and understanding the importance of this topic we take an attempt to test the determinants of SMD in Bangladesh. This study is structured as follows: chapter-1 contains introduction and objectives of the study. In chapter-2, we provide a review of the theoretical literature dealing with the determinants of SMD in Bangladesh. In chapter-3, we outline our model and methodology. The results are then analyzed in chapter-4. In chapter-5, we operate some diagnostic tests for validity of obtained results. Finally, we present the conclusion of our study in chapter-6. 1. What is Stability of Money Demand (SMD)? Stability of money demand is a core concept of macroeconomic field that draws attention of economist from the very beginning of macroeconomics. Many economist researchers provide different definitions and concept of SMD from their point of view. Here I shall try to provide a simple definition of SMD considering the views given by the former analysis. According to Milton Friedman (1956) “The quantity theorist accepts the empirical hypothesis that the demand for money is highly stable-more stable than functions such as the consumption function that are offered as alternative key relations. It was commonly affirmed that money was a function of relatively few variables, including income and interest rate. By the mid-1970s. A consensus seemed to emerge that money demand was indeed one of the more stable relationships in economics, reliable enough to serve as a basis for formulating monetary policy. Recently, however, several researchers have found evidence that some specifications of money demand have remained stable through events of the 1970 and 1980s. One common conclusion of these studies is that money demand is highly interest sensitive.

However, despite intensive analysis and empirical efforts, there is no general consensus concerning the stability of money demand functions. The stability problem is analyzed in terms of the money demand function, i. e. the relationship between money stocks and a few key macroeconomic variables such as aggregate income, interest rate etc. 1. 3 Why this study? Realizing the importance of the stability of money demand, least developed, developing and developed countries adopted various necessary steps to maintain a stable money demand. As a result, Bangladesh is realizing the strategic benefit of stable money demand for the rapid growth.

So she has been making continued efforts to maintain stable money demand. In such a perspective, it is economically significant to make a complete study about SMD. The rationale of this study is described as follows: SMD has come to be viewed as an increasingly important source of monetary sector. For example, euro area money demand was stable until the European Monetary Union (EMU) started in 1999. After this period EMU had changed their monetary strategy. Monetary economic stability was affected by this step. Simply it was occurred for unstable money demand.

So, monetary economic stability depends upon the stability of money demand. Bangladesh is one of the popular LDCs in the world. Here, people’s earnings and spending are highly related. That’s why money demand stability is a much prominent factor to read consumer behavior. Like any other countries Bangladesh’s money demand must be stable. But, there are many factors which Bangladesh must focus on to maintain the stability of money demand. That’s why study on SMD is so important. 1. 4 Objectives of the study: Instability of money demand causes recession, income inequalities in the world.

In the name of globalization developed countries are exploiting developing countries and nations are facing problem of inequality more than now than ever before. And today’s world especially the developed countries are facing the recession originated from credit crunch in USA. Bangladesh also passing through these kinds of economic changes and its money demand stability has been affected. So, the specific objectives are: 1. To identify the potential determinants of the stability of money demand in Bangladesh. 2. To examine the relative significance of main determinants of money demand in Bangladesh based on time series data. . To suggest some policy measures for maintaining the stability of money demand in Bangladesh based on empirical results. So, it is essential to identify, what factors determine the stability of money demand in Bangladesh. After that, we will be able to identify the reasons behind the shift of money demand in the country. For this reason the study “Stability of Money Demand in Bangladesh” will be very meaningful. CHAPTER-TWO A REVIEW OF LITERATURE Anderson (1985) made an empirical analysis name “The Stability of Money Demand Functions: An Alternative Study”.

In his study two types of approaches had been taken for analyzing money demand stability. They were (i) conventional approach and (ii) alternative approach. In case of conventional approach it was assumed that money stocks were demand-determined and that changes took place along the demand curve for money. On the other hand, alternative approach had considered two things. They were “Buffer stock” or “Shock observer” function of money and the notion of “Monetary disequilibrium”. To explain these two approaches had been applied: a) Simultaneous model approach and b) Single equation estimates.

In case of conventional approach a distinction was introduced between short and the long-run demand for money and an special feature was that money supply was assumed to accommodate all changes in the demand for money. On the other hand, alternative approach considered “buffer stock” or “shock observer” function of money and the notion of “monetary disequilibrium” to explain the SMD. In this paper it was found that disequilibrium approach was generated more satisfactory dynamic adjustment process in money markets to make money demand more stable.

Here he showed that tests and analyses was confined to conventional money demand functions were not sufficient for explaining money demand. Oskooee and Shin (2002) conducted a study on “Stability of the Demand for Money in Korea “. Here, they assumed that demand for money depends on a measure of income, interest rate and exchange rate. They used Johansen-Juselius (1990) co-integration analysis method for estimating. M is indicated as real monetary aggregate (M1, M2 and M3). M1, M2 and M3 were money demand functions.

Their empirical findings showed that in Korea none of those monetary aggregate had a stable relation with income, interest rate and exchange rate. They suspected that when more observations become available beyond East Asian Crisis Period of 1997, the relations would become more unstable. Schabert and Stoltenberg (2005) in their working paper series titled, “ Money Demand and Macroeconomic Stability Revisited “ indicated that macroeconomic stability are highly sensitive under an interest rate policy regime, equilibrium and stability is likely to be ensured by a constant money growth policy.

They suggest that a central bank should control the supply of money than the nominal interest rate. In the study entitled, “ Stability of the Demand for Real Narrow Money in Indonesia “ by Anglingkusumo (2005)-he pointed out that demand function for real narrow money balances in Indonesia does not suffer an intercept break, and real narrow money and real consumption in long run relationship co-break during the Asian Crisis. Here, he has proved that the short run demand for real narrow money balances is affected by agents’ seasonal preference for the demand for real money balances.

Realizing this importance the Central Bank of Bangladesh is taking various steps to maintain a stable money demand. A number of modifications of existing policies and provisions for maintaining money demand stability in the country have been made. In previous studies concerning this perspective everybody describes stability of money demand in terms of interest rate, income level and all other macroeconomic variables. But, those literatures didn’t consider the interest rate difference.

According to macroeconomic theory, higher interest rate abroad leads to capital outflow and higher interest rate at home leads to capital inflow. In this study, we will examine how interest rate difference influences the stability of money demand and to what extent in case of Bangladesh. After reviewing pervious studies, we can conclude that two important factors, interest rate difference and one year lagged value of money demand, were left out from their analysis though they are supposed to be highly significant. We have to study about it. CHAPTER-THREE METHODOLOGY AND EMPIRICAL MODEL

The model specification is consistent with the existing theories of demand for money where the stability of money demand in Bangladesh depends on some variety of characteristics of Bangladesh. The dependent variable represents Bangladesh’s stability of money demand or equilibrium money demand or money supply. 3. 1 Methodology, Variable Definition and Data Sources: To explain the role of factors in determining SMD in Bangladesh, this study uses the Ordinary Least Square (OLS) as an estimation technique. Data used in this study are secondary time series (annual), from the period 1973 to 2008.

Most macroeconomic time series are non-stationary by their nature, that is, they have unit roots. These series can be made stationary through differencing or detrending. The time series considered in this study are also likely to be non-stationary in their levels. Therefore the traditional empirical techniques such as the ordinary least square (OLS) may not be applicable to such data. The literature recommends that the techniques of detrending or differencing for non-stationary series. However, these techniques provide desired results when the sample size is large.

Though the study employs a sample size of 36, which is considered to be too carry out unit root test but here we apply unit root test and differencing (in 4. 1 section) to check stationarity for validity of OLS regression. I. [pic] =Natural Log of currency outside banks indicates money demand in billion taka and it is nominal. Source: Economic Trend from 1973 to 2008. II. [pic] = Interest Difference is taken by subtracting Bangladesh’s Deposit’s Yearly Interest Rate (%) from USA’s Treasury Constant Yearly Maturity Rate (%). Source: www. federalreserve. gov/releases/h15/data. tm and Economic Trend from 1973 to 2008. III. [pic] = Natural Log of nominal GDP of Bangladesh is in billion taka. Source: Bangladesh Statistical Year Book-Various Issue. IV. [pic] = It is one year lagged value of money demand. V. [pic] =Dummy variable which is used to see the impact of financial sector reform program initiated since the late 1980s, which involves the elimination of credit controls, deregulation of interest rates, easing of entry into the financial services industry, development of capital markets, increased prudential regulation and supervision and liberalization of international capital inflow.

For the period 1973-1980 [pic] equals [pic] and beyond this period [pic][pic] equals [pic] because financial liberalization has taken place from this period. Because financial liberalization has taken place from this period (1980-1981). [pic]Higher interest rate difference will lead to lower money demand. Because, rising interest rate of USA will be the cause of capital outflow from Bangladesh. Thus, capital accumulation in Bangladesh will be lower. It will cause production to fall in turn. Nominal GDP of income is directly related with every kind of money demand.

If previous period’s money demand increased, it will affect current year’s money demand negatively. Because, increasing demand for money occur disequilibrium in the money market. To balance the money market rate of interest begins to rise. As a result, money demand in the present period will fall. That’s why, we assume that there is an inverse relation between current and previous period’s money demand. So, coefficient ([pic]) of one year lagged value of money demand will be negative. 3. 2 Limitations of the Study: The sample size used in this study is not so large for a time series analysis to have a representative result.

In addition, all the relevant variables can not be included in this model because of data constraint. Besides, we are to face the problem of inaccuracy of data. For example, we have not had the accurate data for the variable, money demand and we took currency outside the bank as proxy for money demand. Moreover, this study lacks strong theoretical background as only a few studies in this field have been done. 3. 3 The Conceptual Framework: Country specific studies find that SMD of Bangladesh depends on Interest Rate Difference and Nominal GDP or Income.

Thus, most of the relevant variables considered are based on the theories and the previous empirical literature for examining the stability of money demand in Bangladesh. After reviewing all the potential determinants of SMD, we adopt the final SMD function: [pic][pic] CHAPTER-FOUR EMPIRICAL ANALYSIS 4. 1 The Unit Root Test: We use Dickey-Fuller (DF) test to operate the unit root test. We consider following equation; [pic][pic] Where, t is trend variable in each case, both hypothesis is that, [pic] (Time series is non-stationary) [pic]

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