Determinants of Demand for Money in Romania Coordinator : Professor Moisa Altar Author: Andreea Paunescu - Bucharest, June Academy of Economic Studies - Doctoral School of Finance

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 2 First Step: Why the interest in studying the money demand? (Some practical aspects) appropriate monetary policy actions (stable function, limited number of parameters) recently, special interest on developing countries (flexible exchange rate, globalization of capital markets, domestic financial liberalization and innovation) predict the effects on ultimate target variables through shocks on monetary aggregates

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 3 Key - features of Romanian economy after 1990 inflationary process lasted much longer that in the majority of ex-communist countries intermediate objectives of monetary policy in Romania until the end of exchange rate since the beginning of liquidity sterilization complete liberalization of the foreign exchange market the final objective of NBRs policies is keeping inflation under control

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 4 Conceptual approach to determinants of demand for money Basically, money serves four major functions: 1. Medium of exchange 2. Store of value 3. Unit of account 4. Source of deferred payment

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 5 Functional Form - The Basic Model The basic model resulting from the theory can be summarized as follows: (M d / P) = f (y, R or, R oc, I, e) (1) where: M d / P = demand for real money balances (either M1 or M2) y = scale variable (real net income, Gross Domestic Product, etc) R or = own rate of money (for that monetary aggregate) R oc = opportunity cost of holding money (for that monetary aggregate) I = inflation rate e = fx rate.

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 6 Applying the general model to M1 and M2, respectively Narrow Money (M1) M d / P - real M1 as a ratio between nominal M1 and Consumer Price Index R or - own rate of M1 computed as a weighted average between 0 (for cash) and the interest rate on current account R oc - interest rate for deposits at Commercial Banks Broad Money (M2) M d / P - real M2 as a ratio between nominal M2 and Consumer Price Index R or - interest rate for deposits at Commercial Banks R oc - average nominal interest rate paid on TBills

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 7 Assumed / expected signs of the dependencies in the general model The long-run real demand function is assumed to be: increasing in y decreasing in those elements of R representing rates of return on alternative assets increasing in own rates of return decreasing in inflation and also decreasing in exchange rate.

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 8 Empirical Approach The aim of the present work and the steps followed: 1. Testing for stationarity in the series 2. Testing for cointegration between the two monetary aggregates and the specified variables, using a VAR Model and Johansen Cointegration Test 3. Estimating the short-run dynamics and the speed of adjustment to the long-run relationship through a VEC Model 4. Relating the coefficients obtained with the effective Romanian economic stance

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 9 Data Description Sample: 1997: :12 Series used: »ln_real_m1 »ln_real_m2 »ln_rio »int_rate_depos »ln_fx_rate »inflation

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 10 Plots of ln_real_m1 (level and first difference)

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 11 Plots of ln_real_M2 (level and first difference)

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 12 Plots of ln_rio (level and first difference)

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 13 Plots of int_rate_depos (level and first difference)

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 14 Plots of ln_fx_rate (level and first difference)

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 15 Plots of inflation (level and first difference)

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 16 Unit Root Tests Applying the ADF Test all time-series appear to be integrated of order 1 I(1), less the inflation which is I(0)

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 17

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 18

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 19

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 20

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 21

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 22 The Specification of the Long-Run Relationships Following the traditional approach the basic model is specified in a log-linear form, with the exception of inflation and interest rate: ln(real_M1) = a 0 + a 1 y t + a 2 I t + a 3 e t + a 4 R t + t (2a) ln(real_M2) = a 0 + a 1 y t + a 2 I t + a 3 e t + a 4 R t + t (2b) After determining the order of integration in the variables of interest, the Johansen procedure is applied to a VAR version of equations (2a) and (2b) to test for cointegration.

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 23 » owing to the short–length of the available time–series I began with a general four order ( a quarter of the year) VAR. » optimal number of lags to be included in the VAR is 4 ( based on LR and AIC criteria) » this makes sense intuitively taking into account that the data is monthly and the sample is relatively short. Lag Length Structure

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 24 Cointegration Results for Equation (2a)

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 25 Cointegration Results for Equation (2b) Hence there is no cointegration between broad money and the variables considered.

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 26 Testing the Errors in the Long-Run Relationship for Narrow Money M1 The long-run relationship: We will compute the series of residuals from the long-run equilibrium relationship and test the resulting series for stationarity: Resid01= ln_real_m ln_rio infl ln_fx_rate + 6.3*10 –5 int_rate ln_real_m1 = ln_rio infl – ln_fx_rate – 6.3*10 –5 int_rate (rel. 3a)

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 27 Unit Root Test on Residuals of Equation (3a)

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 28 Plot of Residuals and Their Significance As the series of residuals is I(0) we can conclude that the values of M1 estimated by the long-run equilibrium equation (3a) dont drift apart from the effective values so that the estimation is good.

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 29 The Error Correction Model Our purpose of building an ECM was to capture the dynamics of money demand in the short-run and especially to identify the speed of adjustment as a response to departures from the long-run equilibrium the first-difference of logarithm of real narrow money, is regressed on the lagged value of the error correction term (the residuals from the long-run relationship), lagged first-differences of time series from the long-run relationship and random disturbance.

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 30 Speed of Adjustment in the Short-Run

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 31 Testing the Residuals in the Short-Run Relationship for Narrow Money M1 Plot of the series of residuals ADF Test on resid02 ADF Test Statistic % Critical Value* % Critical Value % Critical Value *MacKinnon critical values for rejection of hypothesis of a unit root.

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 32 Conclusions We chose the sample 1997: :12 in order to leave behind the peaks of inflation at the beginning of the year 1997 due to foreign exchange market liberalization and to test the relationships under the new market conditions The results we got on M1 is the following long-run relationship which we demonstrated to have nonstationary residuals: ln_real_m1 = ln_rio infl – ln_fx_rate – 6.3*10 –5 int_rate With regard to M2 we didnt find any cointegration. This conclusion is not very surprising given the way than we constructed the model for M2 which is unconsistent with the theory. The reason is the lack of statistical data for a rate that could be assimilated with an opportunity cost for holding M2. This variable should be in the most appropriate case the rate of return on Tbills.

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 33 Conclusions The coefficient of logarithm of real industrial output, has an expected positive sign, meaning that a increase of 1% in the industrial output generates an increase of % in the demand for real narrow money. It is the income (GDP) elasticity of money demand. The sign of the coefficient of inflation is also positive, meaning that an increase in the inflation rate generates an increase in the demand for real narrow money. Although not expected, the sign of this coefficient has particular meaning in Romania and can be justified by: –an increase in the stock of money holdings due to anticipated higher expenditure in the future given the increased level of prices (high level inflation memories of the population in the past years) –the lack of alternative assets which makes currency in circulation, deposits and real assets almost the only possible means of holding wealth –low investitional culture of population which is basically consumption-oriented Interpretation of the coefficients:

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 34 Conclusions The sign of the coefficient of interest rate has an expected negative sign, but it has a low absolute value, denoting that the agents didnt perceived during the studied period the interest rate at deposits as a guide for whether or not to keep their wealth in cash or deposits. This is also because in many periods the real interest rate was negative so that its movements didnt influence M1. The elasticity of foreign exchange rate is negative, meaning that an increase of 1% in foreign exchange rate generates a decrease of % in the demand for real narrow money. This result is expected because the depreciation of foreign exchange rate represents a cost of holding the domestic currency. From the short-run relationship, we got the value of the error correction coefficient which is , which means that if narrow money was below equilibrium in the previous period then it will be increased in the current period. The value indicates a rather slow convergence towards equilibrium.

29 June 2002Andreea Paunescu - Determinants of Demand for Money in Romania 35 Conclusions The impact of inflation and foreign exchange rate is similar (opposite signs, but almost equal absolute values) which reflects the importance that the agents in Romania give to inflation rates and to fx rates in predicting the future evolution of the prices and in allocating their wealth among alternative assets. Among the limitations of the model are the following: –limited number of factors taken into consideration, especially the lack of different types of interest rates (different maturities, different products). This will be achieved as the financial sector in Romania develops –the speed of transformations in an economy in tranzition makes it unlikely to reach stable results with a high probability of being confirmed in time –the short time-series considered, which can give little significance to the results.