A money Demand Function with Output Uncertainty, Monetary Uncertainty, & Financial Innovation WOON GYU CHOI SEONGHWAN OH Class: Macro-economic Theory Dr. Mohammad Al-Sakka Date 20th March, 2011 Presented by Sareh Rotabi

Outline Introduction Hypothesis Data and Methodology Result discussion Conclusion

Introduction The world is inhabited by rational agents who hedge their portfolios against a backdrop of macroeconomic uncertainties before making any decision. The instability of money demand functions in the U.S. after the mid-1970s received wide attention. Many researchers have studied the money demand function and its relation with economic uncertainties.

Introduction Objective: To resolve the instability of M1 demand starting from 1968 till early 1990s through introducing new variables in the analysis of money demand function.

Introduction What is money demand function or in another word, what do we mean by demand for money? And what does the stability of money demand means?

Introduction Demand for money is a decision about the form in which to hold your wealth. The stability of money demands means that the relation between money demand, interest rate and income remain unchanged over time.

Introduction Demand for money depends on: -Income -Interest rates M/P = f(i,Y) V= Velocity of money P= Price level y= Real income/ Out put/ GDP Y= Nominal income/ Output/ GDP- Py M= Quantity of money supplied Md= Quantity of money demanded i= Interest rate

Hypothesis Does output uncertainty and monetary uncertainty as well as output, interest rate, and financial innovations affect money demand?

Methodology 1st approach: Theoretical Model and Money Demand Function using Money in the utility function (MIUF). Consideration: Agents make forecast about output and inflation conditional on the information set available when they decide on their money holding. The cost of financial innovation that facilitate the transactions Findings: The following variables affect money demand -Output uncertainty -Monetary uncertainty -Transaction volume -Interest rate

Methodology 1st approach, cont. -Unlike Friedman and Schwartz who found the income elasticity of money demand to be almost unitary over the period 1868-1975, this article shows that estimated income elasticity of money demand tends to be far less than unity when the postwar data are extended to the early 1990s. -The difference may reflect missing variables arising from financial innovation

Methodology 2nd approach: Empirical Investigation (Money Demand Cointegration Test and Error Correction Regression of Money Demand), using quarterly U.S. data for M1, price level, real income, and interest rate. Consideration: -Money demand function includes: Financial service Output uncertainty Monetary uncertainty

Methodology 2nd approach, cont. Sample period: 1963-1996 -Price level measured by implicit GNP deflator -Real income measured by real GNP -Market rates measured as the three-month treasury bill rate (RTB), the six-month commercial paper rate (RCP), or the ten-year Treasury bond rate (R10) -The own rate of return on M1= RM1 -Opportunity cost= market rates – RM1 The data may involve shocks from the money demand side, e.g. Financial technology shocks which its uncertainty positively influence the demand for money

Methodology 2nd approach, cont. Findings: -The estimate of income and interest elasticities are sensitive to the ending date of the postwar period sample. To reduce the correlation between income and interest rate, the sample period has covered many years beyond 1982. -Extending the sample period to early 1990s, results in an income elasticity of far less than 1. The model delivers a high income elasticity of money demand consistent with cross-sectional evidence

Methodology 2nd approach, cont. Findings: The behavior of money demand appears to be affected negatively by output uncertainty and positively by monetary uncertainty The implementation of disinflationary policy add positive and negative affects to the effects of output uncertainty and monetary uncertainty, respectively.

Methodology Variables in money demand functions

Methodology Residuals from cointegration regression

Methodology System D performs better than other systems, where: Missing money disappears Great velocity decline M1explosion weakened

Result & Conclusion The U.S. M1 demand puzzles during certain episodes are largely due to misspecification of the money demand function rather than to actual economic behavior. The result is supported through an empirical evidence in a long-run, mainly by adding the financial service along with other variables.

Feedbacks Past theories may not verify the current or the expected behavior of the economy. I believe, it is our generation’s role to manifest the ambiguities

Thank you & Happy Nowrooz 