estimating the demand for money in an unstable open economy….pdfVIP

Economic Issues, Vol. 13, Part 1, 2008 Estimating the Demand for Money in an Unstable Open Economy: The Case of the Fiji Islands Paresh Kumar Narayan and Seema Narayan1 ABSTRACT In this paper, we estimate Fijis money demand function for the period 1971- 2002 based on the bounds testing approach to cointegration, which is applica- ble irrespective of whether or not the underlying variables are non-stationary. We estimate models with and without a time trend and for lag lengths ranging from 1-3, but fail to find any evidence for a long-run relationship. Moreover, our structural break analysis suggests that the unstable nature of Fijis money demand may be due to atypical events, such as coups; the implementation of policies, such as devaluations and value added tax; and the onset of trade lib- eralisation policies over the last two decades. 1. INTRODUCTION A simple money demand function implies that demand for money depends upon a variable that reflects the level of transactions in the economy such as real income or wealth, and another variable that reflects the opportunity cost of holding money such as the interest rate. Theoretically the relationship between income and money demand is expected to be positive, while the rela- tionship between the interest rate and money demand is expected to be nega- tive. These relationships are important for they are relevant in macroeconom- ic analysis, particularly in selecting appropriate monetary policy actions, where the stability of the money demand function is considered to be an important prerequisite for effective money targeting. Moreover, a monetary policy aimed at restricting the supply of money facilitates demand management and is able t