Download TIME SERIES ANALYSIS OF DEMAND FOR MONEY IN

TIME SERIES ANALYSIS OF DEMAND FOR MONEY IN
BANGLADESH
Mudabber Ahmed
Submitted in partial fulfilment of the requirements
for the degree of Master of Arts
Dalhousie University
Halifax, Nova Scotia
August, 1997
O Copyright by Mudabber Ahmed, 1997
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contents
List of figures
List of tables
Abstract
Acknowledgements
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X
CHAPTER 1: INTRODUCTION
1.1 Importance of a money demand study for Bangladesh
1.2 Purpose and plan of the study
CHAPTER 2: A BREF SURVEY OF THE THEORY OF DEMAND FOR MONEY
2.1 Fisher's quantity theory
2.2 The Cambridge cash balance approach
2.3 The Keysian approach
2.4 The shopping t h e mode1
2.5 Friedman's restatement of the qumtity theory of money
2.6 McCallum and Goodfiiend mode1
CHAPTER 3: BANGLADESH ECONOMY AND FINANCIAL SECTOR
3.1 Bangladesh economy
3.2 Bangladesh hanciai sector
CHAPTER 4: DEMAND MODEL FOR MONEY IN BANGLADESH
4.1 Review of selected previous studies
4.2 A general model
4.3 P d a l adjustment model
4.4 Cointegration approach to demand for money
4.5 Error correction model
4.6 Stability test
4.7 The data
CHAPTER 5: EMPIRICAL RESULTS
5.1 Partial adjustment model
5.2 Cointegraîion approach
5.3 E m t correction modelling
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6
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11
12
14
14
20
CHAPTER 6: SUMMARY
AND CONCLUSION
APPENDIX A: THEDATA SET
APPENDIX B:FIGURES
REFERENCES
LIST OF FIGURES
Fig. 1: Levek of Ml and M2
82
Fig. 2: Levels of exchange rate (q) and interest rate (r)
83
Fig. 3: Levels of Gross Domestic Product (GDP)and degree of monetization (dm) 84
Fig. 4: Levels of inflation rate (inf).
85
Fig. 5: First Merences of log of rea1 M l (Lrml) and log of real M2 ('Ir&)
86
Fige 6: F h t differences of log of real per capita GDP (Irpy) and log of degree of
monetization (ldm)
87
Fig. 7: First differences of real interest rate (ri) and real exchange rate (rq)
88
Fige8: First dserences of inflation rate (if)
89
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LIST OF TABLES
Table 3.1:
GDP Growth Rate
Table 3.2:
Export Earnings of Bangladesh
Table 3.3:
Trend of Impoits
Table 3.4:
Outstanding external debt in Bangladesh
Table 5-1:
Estimates of short run real narrow money and real broad money
Table 5.2:
Forecasts of real narrow money and reaI broad money
Table 5.3:
Chow test conducted sequentiaiïy on partial adjustment models
of real narrow money and real broad money.
Table 5-4:
Resnlts of Unit Root tests
Table 5.5:
Dicky-Fuller Unit Root test Results on the first difference
of the variables
Table 5.6:
Order of integration
Table 5.7:
Results of augmented Dicky-Fuller test on residuals of different sets
of Iinear combination of variables
Table 5.8:
65
Augmented Dicky-Fuller tests on residuals of different sets
of linear combination of variables
67
Table 5.9:
OLS estimation of error correction mode1 of real narrow money
71
Table 5.10:
OLS estimation of error correction mode1 of real broad money
73
Table 5.11:
Chow test conducted sequentially on error correction models of
real narrow money and real broad money.
73
This study investigates the determinants of demand for money in Bangladesh using annuai
observations for the period 1974-95.Partial adjustment approach and error correction
approach are applied to investigate the nature of short nui and long nui determinants and
short run dynamics. Both real narrow money and real broad money are used for cornparison.
Exchange rate and degree of monetizaîion are included in the money demand functions with
other traditional scale and opportunity cost variables which is the specid aspect of the study.
The results of partial adjustment models in the study suggest that both real narrow money
and real broad money foliow a partial adjustment mechanism. However, actual money stock
adjusts to desùed stock almost iristantly. Real per capita GDP, degree of monetization and
real exchange rate have positive effects on money demand in Bangladesh. Conflicting
evidence is found regardhg the role of interest rate in Bangladesh.
Cointegration tests suggest that real narrow money has equilibnum long nui relationship
with per capita GDP while real broad money has that relationship with real exchange rate.
Error correction modelling suggests that short run dynamics in the real money are
significantly affecteci by the error correction term. Le., a proporfion of the disequilibrium
nom one period is correcteci in the next period. Finally, empirical results of this study
undoubtedly establish the superiority of broad money over narrow money in Bangladesh
case. Hence the policy r n b is advised to target broad money whenever possible.
ix
1 want to express sincere gratitude to my thesis supervisor, Professor U.L. Gouranga Rao,
for his insightfiil criticisms, valuable suggestions, and his consistent kindness and caring
throughout my MA programme. 1would like to thank Professor S.Dasgupta and Profesçor
Kuan Xu for reading the thesis and making valuable suggestions.1also would like to thank
Facuity of Graduate Shidies, Dalhousie University, for providing me with fhancid support.
CHAPTER 1
INTRODUCTION
Over the 1 s t few decades, monetaxy economics has become one of the important areas of
economic research. Monetary economics deals with monetaq management and monetary
aggregates. Real economic variables, such as employment and output, are atfected by
monetary aggregates as money is not neutral. A sound theory of demand for rnoney is
generally regarded as central to the theory of monetary economics. A knowledge of the
money dernand equation and its structure are essential not only for analyshg past monetxuy
policies but also for formdating contemporary and futuremacroeconomic policies. However,
prediction of the impact of monetary policy depends on the stability of money demand.
Laumas and Hudak (1986) pointed out that the success of monetary policy depends on the
stability of the demand for money fiinction and on the degree of precision with which it can
be estimated. The estimates of money demand function provide a short-tem indicator of
economic activity and the policy maker can use it as a long terni guide to inflation targeting.
The fluctuations in demand for money uniquely determine the volatility of velocity of money
(Chakraborty and Kulkami, 1992). Accordhg to the monetarists led by Friedman (1956 and
1959), the volatile velocity of money can create serious problems for monetary policy
makers, because in that case the effect of money supply change on nominal GNP becomes
less predictable. If monetarists are correct in perceiving that the demand for money is not
2
significantly affected by interest rate, and that it is a stable function of real GNP and price
level, then an excessive increase in money supply creates idiation in the economy in the
shoa nui. Moreover, depending on the values of liquidity, price and income effects, it is
possible that an excessive increase in money supply is responsible for higher rather than
Iower interest rates in the economy. Hence, an optimum monetary policy is one that adopts
a stable growth rate of money supply, popularly c d e d as the "monetary de".
Keynesians, on the other hand, explicitly make demand for money a h c t i o n of interest rate.
According to them, money demand is very sensitive to rate of interest and thereby discard
consideration of stability of demand for money. Keynesians do not see the need for a stable
money supply because discretionary monetary policy is more desirable to them than the
adoption of rnonetary d e s . Thus a reliable and predictable link between changes in
monetary aggregates and changes in the arguments of the money demand function is crucial
for the success of any policy.
1.1 Importance of a money demand study for Bangladesh
Bangladesh Bank, the central bank of Bangladesh, conducts monetary policy by monetary
targeting, where it uses credit control and support masures to contain the growth rate of the
broad money supply. The quantity theory of money is the theoretical basis for monetary
targeting in Bangladesh. The Bangiadesh Bank projects the growth rate of the broad money
supply by taking into account the forecasts of growth rate of real output, the rate of
3
monetization of the subsistence sector and an acceptable rate of inflation. Once the projected
growth rate of money supply is deteLmined, the Bangladesh Bank tries to keep the actuai
growth rate of money supply within a smaü intemal of the projected rate by controlling bank
credits (Sohrabuddin, 1986; Rahim and Sohrabuddin, 1988). The empincal investigation of
the demand for money in Bangladesh has received little attention. The monetary authority
in Bangladesh is yet to specify and estimate a money demand b c t i o n and test for its
stabiiity. The few studies conducted during the mid 1970s to eariy 90s estimateci simple
money demand fiuictions using traditional econometric techniques. The authors e.g., Ahrned
(1977). Murty and Murty (1978).Rahim and Uddin (1978),Tasiim (1984). Hossain (1993)
have investigated the money demand function for Bangladesh. The problems with these
studies are as follows:
1) The models were specified in logarithmic or log-linear form using traditional scde and
opportunity cost variables. For example some of them used GNP as the scale variable. But
per capita GNP is more appropriate for Bangladesh as it is facing high population growth
rate.
2) They incorporated partial adjustment mechanism to capture dynamics.
3) Except for Hossain's (1993) shidy, stability of the money demand fiuiction was not tested
in those studies. However, Hossain used earlier data set and rapid economic liberalization
which took place in Bangladesh in the early 1990s was not covered in his study.
4) The existing studies did not take into consideration the role of cwency substitution or the
degree of monetization even in the fkamework of partial adjustment model.
5) None of these earlier studies tested for the stationarity of the variables involved in the
4
money demand function. In addition, they did not test for the existence of cointegrating
relationships which is necessary to estimate a diable long run demand h c t i o n for money.
In Bangladesh, the financial sector has been experiencing structural changes since 1980s.
These changes might infiuence the arguments in the money demand hction. To the best of
the author's knowledge, there is no study on demand for money in Bangladesh which
considers the effects of exchange rate and degree of monetization using an error correction
model. There is clearly a need for estimaihg a long nui demand function for money and its
short nin dynarnics in the context ofBangladesh using the most recent data and employing
the new econometrics.
1.2 Purpose and plan of the study
The purpose of this study are two-fold:
a) To estimate both the narrow money and the broad money demand functions for
Bangladesh using the most recent data within the fkamework of partial adjustment model
including exchange rate and degree of monetization with real per capita GDP, real interest
rate and inflation rate and to test whether or not these variables significantly affect the
demand for money. Empirically which definition of money performs better will also be
examined.
b) To develop an emor correction model and to test the hypothesis that the error correction
terni (deviation of actuai value fiom its long run equilibrium path) significantly affects the
short-run dynamics (rate of change of demand for money).
In chapter 2, a brief survey of the theory of demand for money is presented. This s w e y
staas with Fisher's (191 1) quantity theory and concludes with McCailum-GoodEend (1987)
mode1 of a representative agent theory; the theones are sunreyed chronologicaliy. Chapter
3 is devoted to presenting an overview of Bangladesh economy and its hancial sector.
Section 1 gives a brief summary of Bangladesh economy. Special feaîures of the Bangladesh
financial sector are outlined in section 2. Chapter 4 includes seven sections. A review of
some previous studies on demand for money in Bangladesh is presented in section 1. In
section 2, a g e n d money demand fiuiction for Bangladesh is specified. A survey of some
new developments in time series analysis such as unit root test, cointregration test and
specification of an error correction mode1 are discussed in the following sections. Also
included is a section giving the data sources and definitions of the variables involved. In
chapter 5, the ernpirical results are reported and discussed. Findly, in chapter 6, the policy
implications that have emerged £tom the results of this study are summarized.
CHAI'TER 2
A BRIEF SURVEY OF THE THEORY OF DEMAND FOR
MONEY
The quantity theory ofmoney, orighally proposed by Fisher (1 9 1 1). has undergone several
modifications and rehements over t h e . However, the fundamental premise of the theory
and the interpretations thereof stiIi remai.more or less the same. Other theones include the
Cambridge cash balance approach(1917,1920),Keynes (1936), Baumol-Tobin (1952, !956),
Friedman (1956), McCallum and Goodfkïend (1987). It is difficult to provide specific details
of these theones. However, for purpose of this study, a brief review of these theones is
presented in the following sections.
2.1 Fisher's quantity theory
Fisher (19 11) formulated the quantity theory ofmoney. The transactions equation of Fisher
is typically expressed by the following identity:
where M is the quantity of money, V is the velocity of circulation, P is the price level, and
Q is the volume of transactions.
An important implication of the quantity theory is that, other things remaining the same, as
the quantity of money increases the price level also increases by the same proportion.
Fisher's identity links the demand for money to the volume of transactions in an economy
at any t h e and leads to a macroeconomic theory of money demand (Laidler, 1985, p. 47).
In Fisher's formulation, the scaie variable GDP or GNP,serves as a proxy for the volume of
transactions in an economy and thus is an important determinant of the money demand
function.
2.2 The Cambridge cash balance approach
A different approach to the quantity theory of money was developed by Cambridge
economists such as Pigou (1917) and Marshall (1920). For Cambridge economists, holding
money is dependent on an individual's utility which is derived by holding money
conditional upon particula. tastes and considerations, be it personal wealth, expectations
regarding the future, or the r e m on other assets. Since this approach is based on individual
behaviour, the deterrninants of money demand are different nom those of Fisher's quantity
theory. Furtherrnore, if the demand for money, captureci through the utility hction, is based
on an individual's nominal income, the same should also hold for the aggregate economy as
weil. Money demand, for Pigou, would then be based on the velocity of income rather than
the transactions velocity which was Fisher's concern (Laider, 1985, p. 50). According to the
Cambridge school, price level is tied to the demand for money.
2.3. The Keynesian approach
The demand for money, according to Keynes (1%6), is governed by the liquidity preference,
which, in tum, is governed by three motives for holding money: the transactions motive, the
speculativemotive and the prewtionary motive. Keynesian theory recognizes the firnction
of money not only as a medium of exchange but also as a store of value. The transactions
demand for money ,which consumers require for their &y-to-day transactions, is directly
related to income. Keynes however, did not considertransaction costs in his treatment of the
transactions demand for money. Keynes M e r hypothesized that an individual requires
some money for meeting unplanneci purchases; thus the precautionary motive for holding
money also depends on the level of income.
The special feature of Keynesian theory of demand for money is the introduction of asset
demand for money which d s e s when people tend to hoid money when they expect bond
prices to fa11 (Le. interest rates to rise) and vice versa. Although both the speculative and
precautionary motives deal with uncertainties, yet they are different. Keynes based the
speculative demand for money on uncertainties regarding the fbture level of interest rates.
It is expected that when the rate of interest is expected to rise, the demand for money would
fall since individuals have the incentive to hold bonds for purposes of reaping capital gains.
It upholds the store of value h c t i o n of money which was conspicuous by its absence in the
classical theory of demand for money. One major problem with Keynes' treatment of the
speculative demand for money is that individuals are assumed to hold their liquid assets in
the form of either money or bonds, but not both.
2.4. The shopping time model
Keynes did not consider transaction costs in his treatment of the transactions demand for
money. It was Baumol (1952) and Tobin (1956) who considered the cost of making
transactions and derived the transactions demand for money as a fûnction that involves the
number of transactions and the average holding of money per penod that minimizes
transactioncosts. This is hown as the shoppingt h e model which is based on the following
assumptions:
1) The typical household expenditure during a given period is c in real terms and cP in
nominal terms.
2) Purchases are spread evenly over t h e and this purchases must be paid for entirely with
money.
3) Income is received at the start of the penod in the form of direct bank deposit. The bank
pays interest at the rate R, which can not be used for making purchases.
4) Each transaction (either withdrawai of money fkom the account or payrnent into it)
involves a lump-sum cost 6 in real terms and 6P in nominal temis.
If the individual does not hold al1 the money for the whole period, he or she can eam some
interest. In this mode1 the household receives cash for the period's purchases by making one
transaction in the amount of cP, or two transactions in the amount of cP/2, or three
transactions in the amount ofcP/3 and so on. In particular, if n is the number of transactions,
the cash receipt will be in the amount of cP/n and average money holdings will be
T'usby increasing the number of transactions, intaest earnings can be increased and average
money holding can be decreased.
However, every transaction also involves the broker's fee. Ifthe cost per transaction is 6P
then for n transactions, the cost over the period wilI be, 6nP, while the interest foregone is
RM. So the totai cost is
The minimum transactions cost is found by dinerentiating TC with respect to M, setting
equal to zero and solving for M. Since the second order derivative is positive, the cost
minimizingcondition gives the so-called square root law,
Thus the money balances depend on transaction cost 8, consumption expendiîure c, and the
rate of interest R
2.5. Friedman's restatement of the quantity theory of money
According to Friedman (1956) an individual's demand for money is a function of
opportunity cost of holding money and the total amotmt of wealth in his possession.
Friedman's (1 9%) restaternent of the quantity theory pardels Tobin's portfolio approach
regarding the primary role of money as a fom of w d t h (Goldfeld and Sichel 1990, p.
310).Wealth, which he has categorized into human and nonhuman wealth, is thus one of the
major determinants of money demand. According to Friedman, money demand depends
upon the ratio of human to nonhuman wealth, the higher the ratio of human to nonhumau
wealth, the higher we expect the demand for money to be, other things remaining the same
(Cuthbertson, 1985). Friedman posits that one aspect of the opportunity cost of holding
money is the expected r e m on bonds. However, since there exist assets other than money
and bonds that individual may ho14 Friedman considers the rate of return on these assets as
a part of the opportunity cost as weU (Goldfield and Sichel, 1990, p. 3 10). Expected rate of
return also plays a role in Friedman's money demand fimction.
Friedman's money demand fimction c m be expressed as:
where M is the demand for money, Y is the permanent incorne, P is the price level, r, is bond
yields, r, is equity yields, W is the ratio of hurnan to nonhuman wealth and x' is the expected
rate of inflation. In Friedman's formulation the variables Y and W are expected to have
positive effects and the rest are expected to have negative effects on the demand for money.
2.6 McCallum and Goodfriend model
McCallum and Goodfriend (1987) model is based on the optimiPng behaviour of a
representative agent. They start with a hypothetical household that wants to maximize a
multi-period utility function ai time t:
where Ctand L,are consumption and leisure respectively in time period t. The intertemporal
budget constraint facing the househoid is given by the following equation:
where R,is the rate of interest in t h e period t, B,is nominal quantity of loans made by the
household in time period t, Mt is nominal money stock in t h e period t, Pt is pnce level in
time period t, C,is comumption in time period t and y is real income.
The role of money is captured by a shopping t h e fuaction
where S, is the shopping time subtracted fiom leisure in time period t, C, is consumption in
time period t and m,= MJP, is the reai money holding in tirne period t.
Now maximization of multi-period utility function subject to the intertemporal budget
constraint yields ( after some mathematical manipulation ) the foiiowing money dernand
fùnction:
Unlike the other money demand models, this model takes consumption expenditure as one
ofthe scale variables. Like the Baumol-Tobin model, this model is aiso calIed shopping t h e
model. But this model is more general than the Baumol-Tobin model as it imposes no
restrictions on the coefficients of the parameters.
CHAPTER 3
BANGLADESH ECONOMY AND FINANCIAL SECTOR
The People's Republic of Bangladesh emerged as an independent nation on 26 March 1971'.
The area which now comprises Bangladeshwas a part of British India before 14 August 1947
and was a part of Pakistan before 26 March 1971. Over the last 26 years, Bangladesh
economy in general and financial sector in particdar has been experiencing various kinds of
reforms. Just after independence, socialism was e n s h e d as the guiding state p ~ c i p l in
e
Bangladesh constitution though it was abandoned in the late 70s. In the early 80s Bangladesh
entered into a new era of economic and financiai liberalization. A review of Bangladesh
economy which includes some important statistics is presented in section 1. Financial
reforms and its iikely impact on the issues related to money demand fiinction are discussed
in section 2.
3.1 Bangladesh economy
Bangladesh has a total area of 141000 square kilometres (World Development report, 1996).
It has borders on the west, north and east with India Bangladesh is one of the most crowded
countnes of the world, and among nations dependent on agriculture it is probably the most
densely populated. It has a total population of 117.79 million @MF,International Financial
'Bangladesh observes 26 March as independence day and 16 December as victory
day.
15
Statistics,1996);between 85 to 90 percent are Muslim and the remainder is predominantly
Hïndu. The annul population growth rate is 2 per cent (Bangladesh Bureau of Statistics,
Statistical Year Book of Bangladesh, 1995).
Bangladesh is h o w n to be one of the poorest country in the world. Almost all indicators of
the level of living point to a very low standard of living enjoyed by a majority of its
population. Its per capita income is US $247 (World Development Report, 1996). Accordhg
to UNDP Human resource development index, 1992, Bangladesh ranked 146 among 173
couniries. Its iiteracy rate is 36.6 percent, mean years of schooling is 2.0, a low enrolment
ratio of 32% for 6-23 years old, and an exceptionaliy high number of adult illiterates with
42.3 million (World Development Report, 1996).
The GDP growth rate of Bangladesh economy remained around 4% during the late 80's and
early 90s; see table 3.1. This growth rate is well below the growth rate registered in the East
and South Asia
The growth rate of per capita real income has been about 1.5 per cent per m
u
m during the
past two decades (Bangladesh Bureau of Statistics, Statistical Year Book of Bangladesh,
various issues). The high rate of population growth and the relatively steady economic
growth has kept the growth rate of per capita real income very low.
Despite progress toward greater industrialization in the midœ1990's,agriculture sector still
Table 3.1 :GDP Growth Rate
Period
Growth rates
Source: Bangladesh Bureau of Statistics, Statistical Year Book of Bangladesh, various
issues. *Bangladesh Economic Survey 1997.
accounts for 30% of the country's GDP (Centre for Policy Dialogue, 1995) and remains the
fulcrum of the economy. Virtualiy 82% of the rural population make their living from
agriculture. The ready availability of large number of poor labour and the hgmented
character of many land holdings have perpehiated a labour intensive style of agiculture and
unequal tenancy relation. Share-cropping is the most cornmon form of tenancy agreement
which heavily favours the landlords. Agriculture is heavily dependent on monsoon rain with
virtually no irrigation facilities. Major agricultural products are rice, jute, potato, pulses,
sugarcanes, tobacco, cotton, tea, oil se& and wheat. Average annual growth in the
agricultural sector was 2.7% and 1.9% over the penods 1980-90 and 1990-94 respectively
(World Development Report, 1996).
Industrial sector produces amund 19%of GDP (Bangladesh Economic Survey 1997). Readymade grnent industry has emerged the most promising industry over the last decade. Within
a few years this industry has employed more than one million people; 89% of them are
women (Heitzman and Worden, 1989 ).
Main exports of the country are ready-made garments, shrirnp, raw jute, jute goods. Other
important exports include tea, leather, animal hides and fish products. Successive
Govemments of Bangladesh have iaitiated a process of trade lïberalization since the early
1980s. As a result, growth in export eamings over the last decade has been impressive. Table
3.2 shows export eamings of Bangladesh in selected years.
Table 3.2: Export Earnings of Bangladesh
Period
Total Export Eaniings
(million US$)
Source: Centre for Policy Dialogue, 1995
Bangladesh exports man-power substaatially to Persian GulfNations. Beginning fkom the
late 1970s, about fifty thousand Bangladesh workers have gone to the Gulf countries each
year. Most of them are unskilled and corne fiom nuai middle-incorne families (Siddiqui,
1986). The funds rernitted to relatives by Bangladesh nationais employed abroad has
increased considerably in recent yean and has become an important source of capital inflow.
According to Bureau of Manpower and Employment Training, Bangladesh eamed foreign
18
refnittances of TakaZ 46.44 billion during the first t a months of the year 1996-97 which was
34.57% higher than that of the previous year.
Bangladesh imports almost every kind of commodity. Grain imports have averaged 2 million
tons a year. Industrial sector is heavily dependent on imports of machinery and parts, raw
materials and a number of commodities used in the production process. Emergence of
SAPTA3has accelerated the process of trade liberaikation among the South Asian Nations.
In spite of an impressive progress in irnport L%eralization, Bangladesh's import growth has
rernained much less robust in contrat to export growth. Table 3.3 shows the trend in imports
of Bangladesh.
Table 3.3: Trend in Imports
( Period
Total Imports (million US$)
Source: Centre for Policy Dialogue, 1995.
The balance of payments position of Bangladesh is characterized by trade deficits since its
2Takais the unit ofcurrency of Bangladesh. 40.075 Taka= 1US $ (IMF, International
Financial Statistics, 1996)
'SAPTA is the acronym for South Asian Preferential Trading Arrangement, the
members of which are Bangladesh, Bhutan, India, Nepal, Maldives, Pakistan and SriLanka.
independence in 1971.
Bangladesh has opted for a foreign aid based development since its emergence. Such a
development has contributed to persistent current account deficit (Hossain, 1989). Table 3.4
shows outstanding extemal debt in Bangladesh. From the entries in the table, it can be
inferred that long term debt burden of Bangladesh has been increasing.
Table 3.4: Outstanding extemal debt in Bangladesh
Year
Debt outstanding ( % of GNP)
Source: Hossain (1989)
High incidence of absolute poverty and income inequality are serious socio-economic
problems in Bangladesh. ALmost 50 per cent of people live below the poverty line4and the
Gini coefficient is -39 (BBSStatistical Pocketbook of Bangladesh, 1993) which shows that
economic inequalities are very prominent.
Although the precise estimate of the rate of unemployment is not available, it is considered
high and has remainesi so because of high rate of population growth and a tow but steady rate
4Poverty iine is defmed by the calorie intake 2122 calories per day per person.
of economic growth.
The above surnmary statistics indicate that Bangladesh economy has been suffering from
multidimensional problans- sluggish economic growth, rapid population growth, high rate
of illiteracy, hi& incidence of poverty and inequality, persistent foreign aid dependency, and
unstable economic conditions. To help solve these problems, effective economic policies
have to be undertaken and that monetary policy can play an important role.
3.2 Bangladesh financial sector
Financiai sector in Bangladesh is characterized by what development economists cal1 the
"financial dualismy'.On one side, there is an organized sector that is modem and attached to
the world market. On the other side, there is an unorganized sector based on small
subsistence economic units. Organized and unorganized money markets coexist. Different
rates of interest are present in the two markets.
The organized money market consists of commercial banks, govemment and semigovemment hancial agencies, rurai banks, cooperative banks, and other forms of financial
intermediaries. They are characterized by specialization of their functions and consequently
enjoy economies of scale. Mer independence in 1971, Bangladesh govemment nationalized
the banking sector. Commercial banks and other hancial institutions were brought under
direct control of the central bank.
21
The unorgafzized market consists of landlords, money lenders and usurers of various typesmerch-,
pawnbrokers and contrabandists. The rate of interest in the unorganized money
market, though not O fficially reporteci, is higher than the rate of interest in the organized
market. Monopoly power of rural Ienders is probably the main reason for the high rate o f
interest in this sector. The criteria of credit-worthlliess employed by £i.nancial institutions in
the organized market precludes a significant majority of nuaiborrowers from the organized
money market making them totally dependent on the money lenders and fiends and
relatives in the unorganized sector. Further, the high administrative cost of advancing loans
to mal1 borrowers who dwell in scattered areas of the countryside is also responsible for the
non-availability of bank loans in nuai areas.
The presence of administrative intervention in the d e t e d a t i o n of interest rate hinders the
development of fkee market forces. Interest rate in the organized sector is comparatively
lower than the international rate. This may be a discouraging factor for the infiow of the
much needed foreign capital into the country. This low interest rate rnay lead to the diversion
of hancial resources nom productive uses in the organized market to unproductive uses
such as the purchase of gold,jewellery, reaI estate and other foms of speculative activities.
This may also result fkom high inflation which emdes the value of money.
Bangladesh has a small underdevelopedfiaancial sector which contributes less than 2 percent
of the GDP. Financial deepening (M2 /GDP),although improving slowly over time at 37
percent, is still quite low as judged by the standards of other developing counûies like India
and Pakistan ( Centre for Policy Dialogue 1995). This may cause a large proportion of
income and consumption to be acquired through non-monetary transactions.
Bangladesh inherited a repressed hancial system fkom Pakistan, when it became
independent in 1971.By nationalipng ali commercial banks (excluding foreign banks) and
other hancial institutions, the role of commercial banks was changed fkom being a provider
of credit to the private sector to a cheap source of credit to both the govemment and pubIic
sector enterprises. The role of commercial banks as mobilizer of financial resources was also
marginalized by keeping the interest rates on deposits very low, which became negative and
fluctuated widely as inflation in Bangladesh rose to record high levels during the early 1970s
and remained around 10-15 percent since the early 1990s. As the reai interest rates on loans
were very low or even negative, bank credit became a scarce resource and the limited funds
that were available for distribution in the private sector were rationed out among those who
were economically and politically powerful. This caused an inefficient use of financial
resources and resulted in the non- repayment of loans by defaulters who were politically
powerful, causing crisis in the banking sector. The low interest rates and the selective credit
allocation policies also caused financial disintemediation, which in tum, reduced the
effectiveness of monetary policy (Hossain 1993, p. 86)'.
In response to pressures h m the IMF and the World Bank,Bangladesh began reforming its
'One of the best surveys of post independence financial reform in Bangladesh is
given by Hossain (1993). For a similar s w e y see Khalily (1987).
23
financial system since the eariy 1980s. Financial reforms took place in three directions. First,
efforts were made to create a cornpetitive banking sector and a viable niralfinancial system.
Second, controls over interest rates, exchange rates and capital fiows were largely removed.
Third, measures were taken to develop the money and capital markets. In 1982-83, the
govemment allowed six private commercial banks to operate in the country in an attempt to
encourage the expansion of credit facilities and to foster competition between the
nationalized and the pnvate commercial banks. Two previously nationaked commercial
banks were denationalized in 1983-84. The govemment dso decided to sel1 49 percent of
the shares of three more nationalized banks, opened up private insurance and leasing
businesses and permitted the estabiishment of private investment companies. Since its
reopening in 1976, the Dhaka Stock Exchange has been growing, albeit slowly (Hossain
1993, p. 87).
In 1990, the governrnent of Bangladesh initiated a five-yea.project of financial sector reform
with a broad agenda. This program included, among others, a liberai interest rate policy,
improved the loan classification system of the banks, introduction of capital adequacy
requirements, improved of the supervision system of the banks, development of the capital
markets and regdatory measures to improve the market, as well as Mproved method of the
loan recovery situation. The reform package also included provision for setting up more
private banks with a view to increasing competition in the banking sector. The Bangladesh
Bank in its new interest rate policy, defineci the floor and ceiling rates on deposits and loans.
The commercial banks were f?ee to establish the exact interest rates on deposits and on loans
within the limits set by the Bangladesh Bank.
In the light of the above discussion regarding the refomation of the financial sector, it is
questionable to estimate a demand fiinction for money in Bangladesh with the same
explanatory variables that were used to estimate a money demand function in the developed
countnes. This is because the special features of the Bangladesh economy and its hancial
sector might influence the detefminants ofmoney demand in different ways. The three basic
issues in specimg the demand for money fiuiction are: the definition of money, the
variables to be used and the stability ofthe money demand relationship. The special features
of the Bangladesh economy described above affect these issues differently fiom the case
of developed countries. We now turn to a bief discussion of these issues. For a more detailed
discussion of these issues, see Meltzer (1963) and Judd and Scadding (1982).
Definition of money
The financial institutions are not deveioped enough to blur the distinctions between different
forms of liquid assets or to provide choice among a variety of such assets. Thus the difficulty
of defining money either in the narrow or in the broad sense applies to the case of
Bangladesh, like other developing countries. Most studies on developing countries follow
the narrow dennition of money used in International Financial Statistics. However, in this
study, both narrow money and broad money will be considered in order to find which
definition fits better in Bangladesh.
Important determinants of the demand for money
In developing countries, most of the studies on demand for money use either current income
measured by GNP, GDP or permanent income as the scale variable. Given the fact that the
average propensity to consume is very high [approximately .90 in the 1990s, (Centre for
Policy Dialogue, 1995)l in Bangladesh, like many low-income developing corntries,
attempts to apply the permanent income hypothesis seem to contradict economic reality. Tûe
use of current income seems to be a more appropriate scale variable. However, problems
arise nom the hancial dualisrn discussed earlier. One difficulty is how to estimate income
in the nonmonetized sector of the economy. As a result, there is an unresolved controversy
on whether to use only the monetized component of national income, or to include estimates
of non-marketed output.
The process of monetization may cause instabiiity of the money demand h c t i o n because
the parameters of the money demand may change over time. Therefore, using the degree of
monetization as a variable is also proposed by Kidane (1986). The ratio of M î to nominal
GNP or GDP is one of the commonly used proxies to masure the degree of monetization
of an economy because it can indicate the relative importance of financial assets in a
growing economy.
The deflator that is used to transfonn nominal income into real income is another issue that
should be addressed. The most commonly used deflators are the GDP deflator, wholesale
26
price index, and the consumer pdce index. Abe et ai (1975), however, contend that per capita
red income [Le per capita nominal income deflated by a suitable price index ] should be used
for countries with rapid population growth.
In developed countries, the interest rate is the most commonly used measure of the
opportunity cost of holding money. The use of interest rate to explain the demand for money
in developing countxies like Bangladesh is questioned by many researchers. The interest rate
might not be a satisfactory measure of opportunity cost in a developing country like
Bangladesh for several reasons. First, interest rates are institutiondy deterrnined and,
therefore, do not reflect the interplay of demand and supply. Second, the monetized sector
of the economy is of limited importance. Third, the degree of substitutability between
money and 0 t h financial assets is very low because of the underdeveloped hancial market
[Wong (1977). Ghatak (1981), Crocket and Evans (1980), Darrat (1986)l. These factors
have prompted to look for a proxy for the interest rate. Crocket and Evans (1980) contend
that the demand for money is a fiinction of income and the expected rate of idlation and that
it is inappropnate to use the interest rate. This is because, in most cases, substitution takes
place between real assets and money and that substitution between money and other financial
assets are not important. Further, where real interest rate is negative, actual or expected
inflation rate is likely to play a significant role reflecting the actual cost of holding money
balances.
Ghatak (1981) however, argued that, in so far as borrowing plays a role as a source of
27
financing economic activity, the interest rate should be used as an explanatory variable
because it is the liak between the organized market and the unorganized market. Thus, still
this issue rem-
unresolved. It should be detennined empirically.
In Bangladesh, some financial reforms had been undertaken recently. In particular, market
forces are ailowed to play their part fkely. Now interest rate is significantly afEected by the
demand and supply factors. As a d
t
,
dropping interest rate may be inappropriate. Further,
real interest rate, which had been negative since the independence of Bangladesh, has now
started to become positive. For that reason, interest rate is included in this study to test the
hypothesis whether or not interest rate is sipnificant in explainhg money demand.
Since Bangladesh is a small open economy, international factors such as exchange rate and
foreign interest rate movements exert their influence on the opportunity cost of holding
money. Money holders have the opportunïty to substitute foreign currency for domestic
currency reducing the money demand. Any attempt to control the domestic rate of interest
by the authorities is, therefore, bound to trigger either currency substitution or an outflow of
capital. Therefore, exchange rate movements should also be considered as measures of the
opportunity cost of holding money. However, foreign interest rate variable is excluded fkom
the study as foreign and domestic interest rates could move together. Oskooee and
Pourheyarian (1990) argued that under the curent international monetary system in which
the world financial markets have become more integrated, the domestic and foreign interest
rates move together. Hamburger (1977) argued that the domestic and foreign interest rates
28
generaily move together and when they do, it is the domestic rate that determines the amount
of money held by the public. For that reason, foreiga interest rate variable is not included in
the present study.
Stability of the demand function
As discussed earlier, the structurai reforms undertaken in the 1980s and 1990s might have
some impact on the stabifity of the money demand hction. Judd and Scadding(l982)
pointed out that the stability of money demand hction depends on the financial and
rnonetary development which includes hancial innovations in the fiancial market. In the
present study, the stability of the money demand function is examineci using the Chow test.
CHAPTER 4
DEMAM) MODEL FOR MONEY IN BANGLADESH
A nurnber of studies were conducted on the demand for money in Bangladesh. Most of these
studies included traditional explanatory variables such as GNP,interest rate and the pnce
level in a regression model purported to explaining variations in dernand for money. But no
efforts were made to include exchange rate and degree of monetization as explanatory
variables and test their significance. A very few of these studies conducted tests regarding
stability of the money demand bction. Most of the researchers specified the model in such
a way that they could utilize the available data. In this regard we can not do any better than
the earlier researchers. However, an attempt is made to specify and estimate a partial
adjusfment model and an error correction model to capture the short dynarnics around long
nui equrlibrium.
In this chapter, a brief review of some previous studies is presented which
will help us identi@ the deficiencies of previous studies and provide some guidance in
formulating a more comprehensive model. In addition, a brief review of unit root tests,
cointegration and error correction approach to modelling a long nui relationship is presented.
4.1 Review of selected previous studies
The first study on Bangladesh money demand was undertaken by Ahmed (1977). h u a 1
observations spanning 1959-60 to 1975-76 were used. He estimated a Cobb-Douglas type
money demand function for narrow money using the ordinary least square (OU)estimator.
29
The equation was:
where r denotes a weighted average of various deposit rates of interest ofcommercial banks,
y is real GNP,A, b,, b2 are parameters and u is disturbance term.
The main flindings of the study were: (1)The rate of interest is statisticdly significant and
negatively related to the demand for money with elasticity Iess than one. (2)The incorne
elasticity of demand for money is positive and greater than one. The author asserted that the
relationship between the quantity of money demanded and the explanatory variables was
stable without conducting any test for stability.
Rahim and Uddin (1978) undertook a similar study using only eight annual observations.
Further, among these observati~m~
two observations were for the period 1970 and 71 during
which the Libation War was fou@
The regression coefficients were statisticay
significant and had the expected signs. They concluded that there was a stable money
demand relationship, though they did not conduct any test for stability.
Murty and Murty (1978) estimated a generalized money demand function (GMDF) based on
Box-Cox parametric transformation. The GMDF was specified as:
where M(t) denotes real money balances, y(t) is GNP. r(t) is the weighted average of the
various deposit rates of commercial banks. P,, Pz P,
A,,& are the parameters and u(t) is a
disturbance term. Note that t denotes the time period.
The data used were annual observations for the period 1960/61- 1975/76. The authors
incorporated different tramformations and considered both equilibrium and disequilibrium
versions. The estimates of GMDF were compared with those obtauied fkom restrictive
models. The restrictions were: case (1) Al=O, &=û; case (2) &=1, A&;
case (3) &=O.
A&;
case (4) 1,=1,AH.A likelihood ratio test was carried out for choosing an appropnate
functional form. Their remlts may be summarized as follows: (1) The Iinear model was
appropnate for an equilibrium version. (2) None of the restrictive models was appropriate
for a disequilibrium version. (3) The behavioural properties of alternative rnodels were
examined by considering the movement of income and interest rate elasticities in the sample
p&od. Predictive abilities of these models were dso examined. GMDF model was found to
be superior to other models that were reported earlier. The results of their analysis were
similar to those of Ahmed's (1977): the coefficient of the rate of interest is negative while
that of income is positive.
TasIim (1984) estimated a money demand function which included, among others, foreign
aid as one of the explanatory variables. He included thé foreign aid variable in the money
32
demand regression model by arguing that Bangladesh, which maintained perpetual trade
deficit to hance its development programmes did not rely on economic forces to restore
extemal balance. It meets the deficit by way of foreign aid or credit granted to it by the
exporting countnes. There is thus an excess of goods and reserves in the market for which
there is no correspondhg income. Foreign aid increases the volume of transactions in the
economy and thus increases the demand for real balances. Other variables were income and
inflation rate.
The author argued that the use of interest rate as an opportunity cost variable is erroneous in
the context of Bangladesh as it did not have any weU developed financial market in which
substitutes for money could be traded.
He estimated a partial adjustment model using annual data for the period 1959-60 to 198182. The results show that the rate of interest was not only insignificant but also had occurred
with the wrong sign. When rate of interest was dropped, a better fit was found. To h d the
variables that are important in dete-g
the demand for money in Bangladesh and the
way they affect it, he estimated a variety of regression models involving different
combinations of variables. The study suggests that the public's desired cash holdings were
positively related to the level of income and foreign aid while it was negatively reiated to the
d a t i o n rate. The study also suggests that the actual real balances adjusted to their desired
level through a partial adjustment process.
33
Hossain (1993) estimated a short run partial adjustment mode1 for Bangladesh wing
quarterly data for the 1976.4-89-1 period. The model was
where m denotes real rnoney, y is real GNP,x is expected rate of infiation. and i is interest
rate.
In his study,real incorne, interest rate and the expected rate of inflation were found to be the
major determinants of money demand in Bangladesh. He tested for the stability of the
model applying the Chow test, CUSUM and CUSUMSQ tests. It was concluded that the
narrow money demand function was unstable during 1982-87 and was stable during the
latter period. The broad money demand function remained largely stable throughout the
1980s, except for the 1982-83 period.
The above mentioned studies, like many other studies on the demand for money in
developing countries, are conventional. The present study is an improvement over the
previous studies in several ways:
1) This study includes non traditional scale and opportunity cost variables such as degree of
monetization and exchange rate in addition to traditionai variables.
2) The issue of alternative definitions of money ( M l and M2) is researched in this study.
3) This study deals with yearly data Ahmed (1977) and Murty and Murty (1978) also dealt
34
with yearly data but with a sample size of 14. This study extends the sample size by
employing yearly data fiom 1974 to 1995.
4) None of the above mentioned studies applied new econometrics such as unit root tests,
cointegrationtests and error correction modelling. In this study,traditional partial adjustment
approach is accompanied by an modem m o r correction approach which will help us
identify merits of each approach.
4.2 A general mode1
Following the theory of money demand and considering the background of Bangladesh, a
money demand f'unction for Bangladesh can be specified as follows:
Where lm denotes the logarithm of real Ml or M . , lpry is the logarithm of real per capita
GDP, which proxies the level of economic activity", inf is the rate of Mation measured by
the rate of change of Consumer Pnce Index, ri is the real rate of interest which is equal to
the difference between nominal rate of interest and inflation rate, Idm is the logarithm of
degree of monetization and rq is the real exchange rate which is equal to the Merence
between nominal exchange rate and inflation rate. Exchange rate is defineci as Takas per US
dollar.
6~ollowing
the suggestion of Abe, et al (1975), per capita GDP is used as a scale
variable for Bangladesh in view of its rapid population growth.
35
In this formulation, the coefficients of lrpy and Idm are expected to be positive and the
coefficients of ri and inf are expected to be negative. Sign of the coefficient of rq is
indetenninate. Because when exchange rate changes, it leads to cmency substitution which
has a positive impact on the money demand. On the other hand, it Ieads to asset substitution
which has a negative impact on money demand. The net effect can be positive or negative
depending on the relative strength of the two effects. This is essentiaiiy an empincal issue.
4.3 Partial adjustment mode1
This mode1 introduces a mechanism for the adjustment of the actual stock of real cash
balances to its desired level in order to separate the long nm equilibrium dernand for money
fkom its short nui demand. This mechanism assumes that:
(4.5)
log m,- log m,, = buog m,*- log m,, )
where m* is the desired stock of real money balances, m is the actual stock of money
balances and the b is the adjustment coefficient which is expected to be between O and 1.
The equation indicates that the actual change is a fiaction of the desired change. Following
the partial adjutment mechanism, the short nin money demand fimction cm be specified as
follows:
The long nin equilibrium demand fûnction for rnoney can be obtained fiom the short nui
money demand function by equating m, to q-,in (4.6). Accordingly, the long run rnoney
demand fûnction takes the following form:
where p,=a,/(l-ad
fori=0.......5.
The adjustment coefficient, b, in equation (4.5) is a c W y 1- a,. Once the short nui fiction
(4.6)is estimated, the estimate of the adjustment coefficient, La6,can be computed and the
long run fiinction can be easily derived.
4.4 Cointegration approach to demand for money
The methodology developed in the previous section, though a popular one, is subject to some
drawbacks. For example it takes just one-period lagged value of dependent variable to
capture the complex short run dynamics. Moreover, most macroeconomic time series data
are nonstationary. If the series are nonstationary, inference dram fkom them rnight be
misleading. To overcome these difficulties cointegration-based error correction modelling
is developed. Unit mot tests can be used to test for staionânty of any given tirne series. Unit
37
root tests also provide information about the order of integration of a t h e series. The
variables integrated with the same order are then eligible to foxm a cointegrating vector.
Cointegration method is developed in this section as a step towards error correction
approach.
Unit root tests
Testing for nonstationarity in variables reached a greater level of sophistication with the
introduction of unit root tests by F d e r (1976) and Dicky and Fuller (1 98 1). The Dicky and
Fuller statistics are used to test that a time series has a unit root. First assume that the t h e
series y, satisfies the following data generating process (DGP):
where E, are identically and independently normally distributed with zero mean and constant
variance. The Dicky Fuller test for nonstationarity is then conducted on a reparameterized
version of the above equation which is obtained by subtracting y,, fkom b o t .sides. Thus we
have
(4-9)
AYC = PYt-, + (5
The significance of estirnated p is tested under the nul1 hypothesis H,,:
p2 O . If we can not
38
reject the H,,the series is nonstationary.The test is implemented through the usual t-statistic
of estimated p, denoted as the t-test. DicQ and Fuller note that, under the null hypothesis,
t does not
follow the standard t distribution, rather it is a function of "Brownianmotion."
They provide critical values based on asymptotic distributions which can be used in
empiricd research.
A s the Dicky-Fuller test is sensitive to the presence of a t h e trend and higher order
autoregressive process which would bias the test, the Augmented Dicky Fuller (ADF) test
was developed to deal with this problem.
Consider an AR@) which consists of a drift parameter (intercept parameter) with time trend:
The ADF test c m be implemented by estimating the following repararneterized models:
(4.12) AY,=a,, + a , Y,, +% t + B yj AYtI+et (j = l...p)
Y,represents a typical variable on which tirne series data are available. Here, the first
equation (4.11) contains an intercept and no trend, whereas, the second equation (4.12)
39
contains both an intercept and a trend. p is chosen such that the residuals are uncorrelated
These two equations can be estimateci by OLS. The s-test statistic is used for testing the
null hypothesis &: a,= 0.
In this study ADF test for unit mots were performed on ail the variables specified in the
mode1 (4.4). ADF tests were dso cmied out on the first diffetences of the variables to
determine the order of integration as aii of them were observed to be nonstationary.
Cointegration tests
The procedure for testing wintegration was suggested by Engle and Granger (1 987)They
describe the concept of cointegration in the folIowing way:
An individuai economic variable, viewed as tune series, can wander extensiveIy and
yet some pairs of series may be expected to move so that they do not drift too far
spart- Typically economic theory will propose forces which tend to keep such series
together- Examples might be shoa and long term interest rates, capital appropriations
and expenditures, household income and expenditures, and prices of the same
commodity in the diffete~ltmarkets or close substitutes in the same market. A similar
idea anses firom considering equiiîibrium relationships, where equilibnimi is a
stationary point characterized by forceswhich tend to push the economy back toward
eqnilibrium whenever it moves away. Ifx, is a vector of ecunomic variables, then
they may be said to be in equihirium when the specific linear conseaint a'x,=O
occurs. In most time periods, x, will not be in equilïnum and the mivariate quantity
= cc** may be called the equilibrium errer.... A series with no detemiinistic
component which has a stationary, inverhile, ARMA representation after
differencing d times, is said to be integrated of order d, denoted x, -I(d). ... If x, and
y, are both I(d) ,then it is g e n d y ûue that the linear combination z, = x, - ay, will
a h be I(d). However, it is possible that z, I(d-b), b*..
It shouid be noted that it
will not generally be true that there is an a which &es 4 1 (O)....The components
of the vector x, are said to be co-integrated of order d, b denote q CI(& b), if (i)
all componaits of x, are I(d); (ii) there exists a vector a (+ O) so that z,= a'x ,-I(d-b),
b>O. The vector a is cailed the wintegrating vector (pp. 25 1-253).
-
-
-
If separate economic series are stationny only after diffefencing but a linear combination of
their levels is stationary, then the series are cointegrated. When variables are cointegrated,
it is possible to test for the existence of a long nm relatiomhip among a group of economic
variables. It means that the variables track each other o v a tirne and even though there may
be deviations ftom the long nm path, they ody last for a h i t e t h e . When the variables are
cointegrated, the long nm relationship is best represented by an error correction rnodel. The
idea is simply that a proportion ofthe disequili%riumh m one period is corrected in the next
period (Engle and Granger 1987).
The EngIe and Granger appmach is also known as a residual test. Ifvariabies in an equation
are integrated of the same order, say I(l), the error term should be stationary, i.e.J(O).
Consider M time series (ytr,,.....y&,each of which is I(1), and the following two regression
rnodels, the first with drift and no trend and the second with drift and trend:
A test for no cointegration is given by a test for a unit mot in the estimated e m x tenns e, of
E, This can be achieved by applying ADF test to the residuals using the following equation:
The nul1 hypothesis a = O is tested using the s statistic.
4.5 Error correction models
The seminal papers of Phillips (1957) and Sargan (1964) have opened new ground in
econornic modehg and laid the foundation for what are now cailed error correction models.
The pioneering efforts of Phillips and Sargan have been followed by a number of studies,
notably the paper by Davidson, Hendry, Srba and Yeo (1978).
Engle and Granger (1987) introduced wintegration-based emr correction modehg. If there
exists a cointegrating relationship between some variable y, and a vector of related
explanatory variables x, then by the Granga Representation Theorem7,there exists a valid
error-correction mode1 (ECM)for that variable y, (Engle and Granger 1987).
Granger proposed that when a wintegrating relationship exists among variables, then there
always exists a generating mechanisrn which he calls " the exror correcthg form", and the
change in each variable will best be explained by the error correction term which provides
an important explmation of the variations in the dependent variable.
'See Granger and Weiss (1983) for detailed proof of the theorem.
Cointegration-based error correction modelling consists of four-steps:
1) The order of integration for each of the variable under consideration is detemiined.
2) Cointegrating regression is estimated by OLS. Note that the order of integration of the
variables involved must be the same. Usudy most economic time series are I(1).
3) Stationarity of the residuals of the wintegrating regression is tested.
4) Finally an ECM is specified. Note that the lagged value of the error term of the
cointegrating regression is taken as the error correction tem. Error correction mode1
provides a way of separating the long run relationship among economic variables fiom the
short nin dynamics.
Depending on the outcornes of the unit mots and cointegration tests, appropriate error
correction models of demand for both narrow money and broad money in Bangladesh will
be specified and estimated. The ECM that will be estimated will take the following general
form:
(4.16)
Amt = 6 + AECT + C yim-i
+Zpj&.j + vt
Where the error correction term is (nq., - â q-J,â is the cointegrating vector, z ,is the forcing
variables at time t, and that m denotes either the narrow or broad money.
According to Hendry and Ericsson's (1991) estimation procedure, a sufncient number of
lagged variables should be included in the ECM to ensure that the residual terrns are i.i.d
random variables i. e. the error terms are white noise.
Jiwan (1991) showed how an ECM can be derived k m a stochastic dynamic programme
where agents try to attain a long run target level of real money balances. He also showed how
the error correction term in an ECM is constrained to a negative value nom a stochastic
dynamic programme. The estimate is therefore expected to be negative as it is the t e m that
maintains the long-run equilibrium.
4.6 Stability test
Effectiveness of monetary policy depends to a large extent on the stability of the money
demand fiuiction. Accordingly, the question of the stability of money demand function
should be addressed. A majonty of researchers, e.g. Goldfeld and Sichel (1990), Haffer and
Hein (1982), Boughton (1981), Ram (1982), Fackler and Wheeler (1982), Judd and Scadding
(1982), Hossain (1993) were interested in testing stabilie of the money demand function.
According to H e n w and Ericsson (199l),
'Tarameter constancy is at the heart of model design both statistical and economic
perspectives. Since economic systems are far fiom being constant and coefficients
of denved ("nonstructural" or 'kduced" form) equations may change when any of
the underlying parameters or data correlations change, it is important to identifi
empirical models that have reasonably constant parameters, which remain
interpretable when change occurs." (p.21)
One of the popular method of testing changes in the parameters between two (more)
regressions is the Chow (1960) test. The entire sample of size n is split into two sub-
44
samples of sizes Say nl and n2. Note that n l + d = n. Chow test then proceeds as follows:
1) Run the pooled regression taking the entire sample of sue n. From the regression obtain
the residual sum of square (sse)
2)Run separate regressions with sample sizes of n l and n2. Obtain their respective residual
sums of squares.
3) Compute the following test statistic:
(4.17)
F = {(sse-ssel-sse2)/k)/{(sse)/nl+n2-2k}
- F (k, nl+n2-2k)
where sse is residual sum of squares fiom the regression over the entire sample consisting
of n observations, ssel is surn of squares of residual fkom the first sub-sample consisting of
nl observation, sse2 is the sum of squares of residual h m the second part of the split sample
and k is nurnber of estimated parameters.
if the test statistic is less than the criticai value fiom an F (k,nl+n2-2k) distribution then
there is no evidence of a structural break.
During the study period, Bangladesh economy had experienced considerable change in its
economic and political structure in general, and in monetary sector in particuiar. Changes
in the industrial sector, pnvatization of banking system, emphasis on fkee market etc. are
some of the important changes that had occurred during the study period, 1974-95. These
changes might have some impacts on the stability of the money demand function in
45
Bangladesh. To test the stability of the models, sequential Chow tests are perfonned.
Sequential Chow test applies the test statistic in equation (4.17). But instead of a single break
point, tests are conducted several break points consecutively. Such test belp us identifi
whether stnicturaI break is permanent or temporary.
4.7 The data
The data used in this shidy are taken fiom the International Financial Statistics Yearbook
{1996), a publication of IMF. Annual observations comprising the period 1974-95 are used
to estimate the model.
Income variable used in this study is per capita GDP. Real GDP is computed by deflating
the nominal GDP by the Consumer Price Index (199û=100).
The Consumer Price Index
(CPI)is used because it is a good indicator of the movement of prices (Crocket and Evans,
1980). Real per capita GDP is obtained by dividing the real GDP by the total population.
The bank rate (discount rate), an average of the monthly bank rate published in the
International Financial Statistics, is used for the nominal interest rate variable. Saqib and
Ahrned (1986) found that the bank rate is highly correlated with time deposit rate and cal1
money rate (correlation coefficients are .91 and .96 respectively) in Pakistan (including
former East Pakistan). The real interest rate is cornputed h m the formula ri, = i, - in&, where
i is the nominal interest rate, i c i s the Mation rate, which is given by [(CPI $PI &PI
J.
The degree of rnonetization is measured by the ratio of M2 to GDP.
Two definitions of money are: the narrow money and the broad money. The narrow money,
denoted Ml, includes currency outside the banking system plus demand deposits. The broad
money, denoted M2, includes time and saving deposits besides Ml.
The opportunity costs variables are in levels rather than logarithms since the formulation
provides practical advantages (Eder, 1995). ln Bangladesh reai interest rates were negative
for many years.
CHAPTER 5
EMPIRICAL RESULTS
Following the theory of demand for money and considering the Bangladesh background,
general demand h c t i o n s for money in Bangladeshwere specified and the new econometrics
were briefly discussed in the last chapter. In this chapter, empirical resuits are reported in the
light of the rnethodology discussed in the previous chapter. Section 1 deals with estimation
of partial adjustment models of M l and M2, their forecasting power and stability. In an
attempt to h d a cointegrating vector, unit root tests and cointegration tests are performed
and their results are reported in section 2. The results of OLS estimation of the cointegrating
relationships are also presented and discussed in this section. Based upon the results of the
unit root and cohtregration tests, appropriate error correction models of Ml and M2 for
Bangladesh are estimated and reported in section 3. The economeûics programme
SHAZAM8was used to compute the numerical results reported in this chapter.
5.1 Partial Adjustment Mode1
The partial adjustment model, which was introduced by Goldfeld (1973),has become a
standard fkamework for modelling the money demand function. Later a vast number of
researchers, e.g., Arango and Nadiri (198 l), Gujarati (1988), Cesarano (199 1). Chakraborty
8SHAZAM:Econometrics Cornputer Program, version 7.0, User's Reference Manual,
McGraw-Hi11Book Company, 1993.
48
and KuIkanÜ ( 1 992), Hossain (1993), Palley (1995), Mcgibany et al (1995) applied this
framework in their empiricd studies. In the present study, partial a d j m e n t models were
estimated for the real nanow money and the real broad money. As mentioned earlier, an
estimated mode1 gives the short nui money demand function. A long nm money dernand
function can easily be computed fiom the estimated short nui function as discussed in the
previous chapter. The results for both types of money are displayed in the same table for
cornparison in the belief that they help us identw the suitability of the two dennitions of
money to the policy maker in Bangladesh.
Estimated coefficients and their interpretation
Following the specification of equation (4.6), the short nm demand fûnction for real Ml and
real M2 were estimated by applying the OLS method. The reSUIts are displayed in table 5.1.
The standard errors, t-ratios and p-values are reported in round brackets, curly brackets and
square brackets respectively directly below their respective parameter estimates. The value
of R2 in the second column of table'5.1 indicates that aimost 95 percent of the variation in
the log of real narrow money in Bangladesh is explained by log of real per capita GDP, red
interest rate, inflation rate, real exchange rate, log of degree of monetizationand lagged value
of log of real narrow money.
Log of real per capita incorne affects positively and s i ~ c a n t l the
y demand for reai narrow
money as expected. Its coefficient denotes the short run elasticity which is 0.80. It indicates
Table 5.1: Estimates of short run real narrow money and real broad money
l
Variables
constant
I
Eshates of red narrow
money
Estimates ofreal broad
money
2,715
(1 .SOS)
(1.445)
[O.1691
1 .O15
(0.015)
(1 -482)
0.008
(0.002)
(0.803)
[O. i 591
[O. 1891
-
ldmt
1.279
(O. 168)
(7.603)
[O.OOO]
1.181
(O.024)
(48.12)
[0.000]
R2= .9997 DW 4.907
R2adjusted = ,9995
50
that there is evidence of economies of scale in holding money in Bangladesh. The degree
of monetization is another significant factor -whichaEects the demand for narrow money
positively. Its coefficient also denotes short n m elasticity. The value is greater than 1 which
Uidicates that a 1% increase in the degree of rnonetization increases the demand for money
by more than 1% in the short m. Thus it supports the hypothesis suggested by some
economists that the degree of monetization is important in explaining money demand in
developing countries like Bangladesh.
The coefficients of interest rate, inflation rate and exchange rate cannot be interpreted as
elasticities as the variables are not expressed in logarithms. However, the impact of a change
in these variables on the log of reai money can be known fiom the magnitudes and signs of
the coefficients. The coefficient of inflation rate has the wrong sign and is not significant.
Such a result is perhaps the consequeme of having real interest rate ,defineci as the nominal
interest rate net of inflation rate, as one of the explanatory variables. The coefficient of real
interest rate has the expected negative sign and significant which indicates that when
opportunity cost inmeases, people hold less money. The view that interest rate plays no role
in explainhg the demand for money in the developing corntries does not h d support in this
study as this coefficient is significant.
The positive coefficient for exchange rate indicates that in the case of Bangladesh, currency
substitution is greater than asset substitution. As mentioned earlier, change in exchange rate
has two effects
- hancial asset substitution effect which is negative,
and currency
51
substitution effect which is positive - on the demand for money. When exchange rate
increases, Taka, the unit of currency of Bangladesh, becomes cheaper compared with other
international curreacies and people (who have portfolio baskets of i n t e d o n a l currencies)
are expected to substitute more Taka for foreign currencies. Thus it leads to currency
substitution which has a positive impact on the demand for money. On the other hand, when
exchange rate inmeases, Taka loses its value. Note that exchange rate is defined as so many
Takas for a US dollar. As a d
t
,
people are Wcely to substitute certain hancial assets such
as stocks and bonds for Taka. This is asset substitution which has a negative impact on the
demand for money. The net effect c m be positive or negative depending on the relative
strengths of the two effects. Since exchange rate has a positive coefficient, it indicates that
in the case of Bangladesh, the net effect is positive. It also implies that the currency
substitution eEect is greater than the asset substitution effect. This hduig has two
implications. First, smailer asset substitution effect (compared with currency substitution
effect) indicates that, when exchange rate inmeases, people substitute fewer financial assets
(stocks and bonds) for money in Bangladesh. This is quite possible, since the financial sector
is not well developed in Bangladesh. People are not familiar with different kinds of hancial
assets such as stocks or bonds and perhaps they substitute real assets such as gold or land for
Other
currencies.
Second, greater currency substitution eEect (compared with asset
substitution) implies that an incme in exchange rate increases the demand for Bangladeshi
currency. Bangladesh, at present, regularly monitors the exchange rate of Taka against a
basket of fifieen currencies. This reflects the fact that at present Bangladesh has more
economic links with other countries than in the past.
52
The regression results for real broad money are also shown in table 5.1. The R2 value
indicates that the overall goodness of fit of the model is excellent. The variables included in
the model explain 99 percent of the variation in log real broad money in Bangladesh. Log
of real per capita GDP and log of degree of monetization have signifiicantpositive effiects on
the demand for broad money. Short nin broad money demand elasticity with respect to per
capita GDP is greater than 1 (elastic) which indicates that money is a luxury good in
Bangladesh. The coefficient of the rate of interest has the negative correct sign though
statistically insignificant The negative sign of the rate of interest indicates that when interest
rate increases, demand for broad money decreases. However, rate of interest does not appear
to be very important in affecting danand for broad money as its coefficient is insignificant.
Mation rate is aiso not significant for reasons given earlier in the case of n m w money.
The coefficient of the exchange rate is positive and significant for broad money. The sign of
this coefficient suggests that currency substitution is greater than asset substitution in
Bangladesh, a result similar to the case of nmow money.
The long run money demand fùnctions for the real narrow money and the real broad money
can be derived £hm the corresponding partial adjustment model as discussed in chapter 4.
For the real narrow money, the adjustment coefficient is 0.98. It means real narrow money
follows the partial adjustment mechanism. But since the value is close to 1, it indicates that
actual money stock adjusts to desired stock very quickly. Now,dividing each coefficient of
the short nui function (the coefficients in the second column of table 5.1) by .98, yields the
following long run money demand fiinction for real nmow money:
(5.1)9
h
l
,
= 2.219 + 0.814 hpyt- 0.036 ri, + 1.035 inf,+ 0.019 rq, + 1.305 I d q
Here the long nin incorne elasticity is .81 which means that a 1% increase in real per capita
GDP wili increase real narrow money demand approximately by .81% in the long run.
Similarly, the coefficient of the degree of monetization also denotes long nui elasticity. This
elasticity is 1.305 which indicates that for a 1% increase in the degree of monetization, real
narrow money demand will increase by 1.30% in the long m. Similarly, here the
coefficients of interest rate, exchange rate and inflation rate show their respective long nin
impacts as these coefficientsbelong to the long run money demand fùnction. The magnitudes
and signs of these coefficients suggest that the long nui impacts are almost similar to their
corresponding short run impacts. In facf the division of aU the coefficients of the short nin
money demand fùnction by 0.98 changes the results very iittle as 0.98 is close to 1.
On the other hand, for the real broad money ,the coefficient of the lagged term (ln&,) is
.002. It means the adjustment coefficient, b is (1-.002)or 0.99 (approx.). Since the value of
b lies between O and 1 it does support the hypothesis that broad money demand also follows
a partial adjustment mechanism. Here, the value is very close to 1 which also indicates that
'Standard error of this h c t i o n is not presented since the size of sample is srnall.
There is no simple way to obtain the standard error of long run f'unction, especially if the
sample size is relatively srnalI. See Gujarati, 1988, p. 528. For large samples, however, The
standard error can be obtained approxhateIy. See Jan Kmenta, Elements of Econometrics,
The Macmillan Company, New York, 1977, p.444.
54
actual broad money stock adjusts to desïred stock almost instantaneously. Now dividing each
coefficient of the short run demand h c t i o n for real broad money (the coefficients in the
third column of table 5.1) by .99, the long run demand fùnction for real broad money is
computed:
(5.2)
lnn2,= 3.863 + 1A64 hpyt- 0.003 ri, + 0.008 inf, +.O06 rq, + 1.182 ldm,
Here the long run income elasticity is 1.16 which means a 1% increase in real per capita
GDP will increase reai broad money demand approximately by 1.16% in the long
nui.
Similady, the coefficient of the degree of monetization also denotes elasticity. The value of
this elasticity coefficient, 1.18, indicates that for a 1% increase in the degree of monetization,
real narrow money demand will increase by 1.18% in the long m. So real broad money is
sensitive to the degree of monetization.
Forecasting power
To take any policy mesure in the fûture, the forecasted values of an estimated model c m
be used. The policy measwes could be successful only if the forecasting / predictive power
of a model is good. Predictive power of a model c m be judged by observing the values of
the root mean square percentage e m r (RMSPE)and mean absotute percentage error (MAPE)
statistics. Predictive power of that model is better which has a smaller RMSPE and MAPE.
Some shidies, for example Palley (1995) study, applied root mean square error (RMSE)
55
criteria to test the predictive power of alternative models. But as it is dependent on the unit
of measuremenf this study does not employ RMSE criteria. To know the forecasting power
of the partial adjutment models for red narrow money and real broad money, the models
were estimated for the period, 1974 -1990, and forecasts were computed for five periods,
1991- 1995. Table 5.2 reports the results.
Table 5.2: Forecasts of real narrow mone! and real broad money
Real nmow money
Red broad money
Year
Year
Observed Predicted Calcdated
log value log value residual
Obsenred Predicted Cdculated
log value log value residual
RMSPE = 4.178
RMSPE = .453
MAPE = 25.087
MAPE = 3.427
In case of real narrow money, as shown in lefi hand column of table 5.2, a compatison of the
observed and predicted values shows that the predictive power of the mode1 is good. Al1 the
predicted values are close to observed dues. But in case of real broad money, a comparison
56
of the observed and predicted values show that predictive power of the model is excellent.
AU the predictive values are very close to observed values. A cornparison of the predictive
power of the model for real narrow money and that for real broad money shows that
predictive power of the latter is better since the value of RMSPE and MAPE are smaller for
real broad money.
Stabiüty test
To suggest appropriate policy measures h m the estimated results reported earlier, it is
essential to examine whether the parameters of the estimated money demand function are
stable over t h e . This is accomplished by applying Chow test to discover significant
clifferences between the parameter vectors of two regressions. Thus the nuil hypothesis &:
There is no structural change (i.e the estimated parameters are same for two sub periods) is
tested against the alternative H, :there is structural change.
By applying the Chow test sequentially it is possible to detect whether the parameters in the
money demand hction are stable or not over thne. The advantage of this sequential Chow
test is that it takes a nurnber of possible break points into consideration instead of just a
single point. The break points stat at t = k+l and end at t = n-k-1,where k is the number of
coefficients. The results of sequential Chow test are presented in table 5.3 for possible
structurai breaks commencing with 1982 and ending in 1988, a period during which crucial
measures of financial liberalization were introduced in Bangladesh.
Table 5.3: Chow test condocted sequentially on partial adjustment models of real
narrow money and real broad money.
F-statistic for
real narrow money
F-statistic for
real broad money
Note: 'denotes significant at the 1%level; denotes significant at the 5% level.
In case of real narrow money, there is evidence of structural break in d l of the seven break
points. The null hypothesis of no structural change is rejected since the value of F statistics
are significant for each break point. It indicates that the parameters in the narrow money
demand fûnction are chmging. In other words, real narrow money demand relationships
found fiom the partial adjustment mode1 are not stable. The resuits suggest that any policy
measures undertaken on the basis of that assumption is likely to be less effective. On the
other hand, the broad money f'unction has been unstable in the early 1980s and stable
therea£ter. There are significant shi& in two of the seven cases. In these cases, significant
shifts occurred in the early l98Os, around the time financial liberalization measures were
58
introduced. It is evident h m the entries in the table that the parameters of real broad money
are more stable than the parameters of real narrow money since the former has two
significant break points against seven of the latter.
Before moving to the cointegration approach, the d t s of the partial adju~fmentmode1 can
be surnmarized as foiiows:
1) The demand for money h c t i o n in Bangladesh foUows the partial adjustment mechanism
and the actud quantity demanded adjusts very quickly to the desired quantity of money
demanded.
2) Log of per capita real GDP, degree of monetization and the exchange rate play a
significant role in determining the demand for money in Bangladesh. Al1 of these three
variables have positive effects on the demand for money.
3) Both the short nui and long run elasticities for real narrow money with respect to real
GDP are less than 1 but for real broad money these elasticities are greater than 1.
4) High elasticity with respect to degree of monetization dso suggest that the demand for
both the namow money and the broad money in Bangladesh are very sensitive to the degree
of monetization.
5) Interest rate has a negative significant effect on the real narrow money but in the case of
broad money it is insignificant.
6) Positive and significant coefficient for the exchange rate suggests that currency
substitution is greater than asset substitution in Bangladesh.
59
A cornparison between the demand function for real narrow money and real broad money
gives some important findings which can be summarised as foiIows:
a) The same set of explanatory variables explain real broad money better than real narrow
money since R2is higher for real broad money.
b) The predictive power is better for real bmad money since the value of RMSPE and
MAPE are lower than that of narrow money.
C)
The parameters of the broad money fiinction are more stable as reflected in the Chow test
conducted sequentially.
The above mentioned d t s establish the fact that the broad definition of money perfoms
better than the narrow de&ition
in Bangladesh. In fact, choice of proper definition ofmoney
is an empirical issue. A number of attempts have been made to d e h e the money on
empiricd grounds. Friedman (1959),Chetty (1969) attempted to establish that for empirical
purpose M2 should be the proper definition of money. In short, the policy maker of
Bangladesh should target broad money.
5.2 Cointegration approach
One of the implicit assurnptions in the partial adjustment model was that all the variables
used in the money demand model are stationary. Ifthe t h e series used in the model are nonstationary, it might give a spurious rcgre~sion'~.
Long nui tme relationship can be found
l'%orspecific details about spurious regression, see Granger and Newbold (1974).
60
arnong variables that are cointegrated. According to Hendry and Ericsson (1991) an
econometnc mode1 must, in the first place, be consistent with economic theory. They argue
that if economic theory suggests that a long run relationship exists arnong economic
variables, then it is possible to discover such a relationship arnong variables with a regression
model using the cointegration approach. Another important reason for testing cointegration
is that if two variables are cointegxated, an OLS regression yields a consistent estimate of
the true coefficient (Engle and Granger, 1987). A Cointegrated relationship can be found
among variables that are integrated of the same order. For that reason, before caryhg out
cointegration tests, unit root tests should be conducted to ascertain the order of integration
of the time senes involved.
Unit root tests on the Ievels of the variables
To test whether the variables involved in the partial adjustrnent model are stationary or not,
unit root tests were performed on each variable using the Dice-Fuller unit root test. The
results of these tests are report& in table 5.4.
Unit root tests without trend suggest that al1 the variables have a unit root, since the
calculated (absolute) values of r, are smaller than the critical value at 10%signincance level.
However, tests with trend variable inchdeci suggest that log of degree of monetization is
stationary since the r,vdues for this variable is greater than the critical value. This indicates
that not al1 the t h e series involved are stationary.
TabIe 5.4: Results of Unit Root tests
Variable
tg(without trend)
r, (with trend)
Asymptotic Critical Values provided by SHAZAM econometrics program
w i h u t trend
with trend
size
This result corroborates the view that most macroeconomic time series are nonstationary.
Nelson and Plosser (1982), for example, found that many macroeconomic variables, such as
GNP (real, nominal or red per capita), industrial production, consumption, wages, cornmon
stock pnces follow a random wak process.
Ifthe senes are nonstationary and are integrated with different orders, long run relationship
found nom the partial adjustment mode1 cannot be taken to be tme. In order to discover the
order of integration, unit root tests were also performed on the first difference of the
variables.
Unit root tests on the first differences of the variables
Unit root tests were performed on the fkst difference of the variables. The results of these
tests (with trend) suggest that all the variables are stationary except that the real rate of
interest is nonstationary without the trend variable.
Table 5.5: Dicky-Fuller Unit Root test Results on the fust ditrerence of the variables
1 Variables
ta (without trend)
sa (with trend)
Inn1
irpy
lm2
ldm
ri
inf
rq
1 Asymptotic Critical Values provided by SHAZAM econornetrîcs program
t,
(without trend)
-2.57
ta (with trend)
-3.13
Size
10%
Since the calculateci values of r, are pater than the critical value for h
l,
M , Irpy, ldm,
infand rq, none ofthem has a Mit root when their first differences are taken. Thus al1 these
variables become stationary when their f k t ciifferences are taken. Real interest rate, ri, with
a trend included becomes stationary d e r taking the h t difference and it becomes
63
stationary, without trend, after taking the second difference. Graphs of the levels of the tirne
series and the £irst differences of tirne series of the variables involved are shown in
Appendix B.
Order of integration
Results of Unit mot tests show that except for the real rate of interest, all the variables used
in the partial adjustment models are I(1); see table 5.6. Cointegration theory suggests that if
the variables are of different integrated orders, they can not fom a cointegrating vector.
Table 5.6: Order of htegration
Variable
order of integration (without trend)
Order of integration (with trend)
L
Cointegration tests
Results of unit root tests in the previous section suggest the presence of a unit root in each
64
of the real narrow and broad money balances, dper capita output, degree of monetization,
exchange rate and inflation rate. Accordingly, they are eligile to f o m a cointegrating vector
or a long run equilibnum relationship. The interest rate is not, however, eiigible to fom a
cointegrating relationship with any of the above variables because it is I(2) without the trend
variable. With a trend variable uicluded unit root test suggests that this variable is also
integrated of order 1, and thus it becomes eligible to form a cointegrating vector. The
objective is to find out which variables are cointegrated with real narrow money and which
variables are cointegrated with real broad money. DifSerent sets of variables were tested to
fïnd out whether they form a cointegratingvector that would represent a long run equilibrium
relationship.
Cointegration involving real narrow money
Cointeption test is useful to find out the cointegrating vector. Estimation of cointegrating
vector shows the long nin equiliiiriumreiationship. Cointegration tests were perfoxmed using
the Augmented Dice-Fuller test on residuals of different linear combinations of variables.
These results are displayed in table 5.7.
Cointegration tests on residuals of v h u s combinations of variables show that residuals in
all the combinations are nonstationary except for the combination 8. It indicates that we can
not reject the hypothesis that the residual in the combination 8 is stationary. Thus, the
variables in that combination h
l and lrpy are cointegrated. In other words, real narrow
money is cointegrated only with real per capita income.
65
Table 5.7: Results of augmenteci Dicky-Fuller test on residuais of dinerent sets of linear
combination of variabIes
1 Combination of variables
-
-
-
-
ze(without trend)
- -
r, (with trend)
l.lrrn1, Lrpy. ri, rq. inf, log dm
Asymptotic critical value at the 10% level
2.h1, irpy, ri, rq, log dm
Asymptotic critical value at the 10% level
3.h1, @y, inf, rq, log dm
Asymptotic critical value at the 10% level
4 . h1, Irpy. log dm, ri
Asymptotic critical value at the 10% level
1 5.h1, Irpy, logdrn, inf
-1.71
-1.71
Asymptotic critical value at the 10% level
-3.81
-4.15
6.h1,Irpy, ldm
-1 -66
-1.51
Asymptotic critical value at the 10% Ievel
-3.45
-3.84
7.Inn1, ri
-2.39
-1.93
-3 .O4
-3 .50
1 Asymptotic critical value at the 10% level
8 - h LQY?
Asymptotic cntical value at the 10% level
Thus the cointegration results show that real narrow money bears a long nui equilibrium
relationship only with real per capita income and not with any of the other variables.
66
Cointegration hvolving real broad money
Cointegraiion tests involving real broad money were also performed ushg Augmented
Dicky-Fuller test on residuals. Different combinations were tested to find out a cointegrating
(more than one cointegrating vector may exist) vectoq see table 5.8.
Cointegration tests on residuals of different combinations show that residuals in d l the
combinations are nonstationary except for the fast. It indicates that we can not reject the nuil
hypothesis that the residual in the combination is stationary. Thus,cointegration tests show
that real broad money b a r s a long run equilibrium relationship only with real exchange rate.
Estimation of cointegrating vector
Once the cointegrating vectors are found, the parameter vectors which yield the linear
combination- can be estimated by ûrdinary Least Square (OLS)method. This estimated
relationship will represent an equilibrium long runrelationship among the variables included
in the vector. Cointegration results show that long run relationship found from the partial
adjustrnent mode1 may not represent the equilibrium long run relationship since these
variables are not cointegrated. Further, real n m w money is found to be cointegrated with
real per capita income and real broad money is cointegrated with real exchange rate.
Thus, these two relationships are estimated using OLS method, the results of which are
presented in equations (5.3) and (5.4).
Table 5.8: Augmented Dicky-Fuller tests on residuals of different sets of linear
combination of variables
1
I
Combination of variables
r, (without trend)
t,(with trend)
l.lrm2, lrpy, ri, rq, in& log dm
-2.78
-3.25
Asymptotic critical value at the 10% level
-4.42
-4.40
-2.75
-3.15
-4.13
4.43
Asymptotic critical value at the 10% level
-3 -45
-3.84
7 . m 9 Irp~,
-0.77
-1.61
Asymptotic critical value at the 10% level
-3.04
-3.50
8. lrm2, rq
-3.34
-2.14
Asymptotic critical value at the 10% level
-3.O4
-3.50
2-
w,
Irpy7 n. rq, 1% dm
1 Asymptotic critical value at the 10% level
3.lrm2, îrpy, infrq, log dm
Asymptotic critical value at the 10% level
4.lrm2, Irpy, ldm, ri
Asymptotic critical value at the 10% level
5.lrm2, .Irpy, ldm
Asymptotic critical value at the 10% level
For real narrow money the estimated equation is:
The standard errors, t-ratios and p-vaIues are reporteci in round brackets, cudy brackets and
square brackets respectively ciirectly below their respective parameter estimates. The
equation shows the long nin parameters of the demand function for real nmow money. In
the long run, real per capita incorne significantiy affects the demand for reai nanow money
in Bangladesh. The intercept is dso significant These d t s suggest that we can use lagged
ermr t
m s nom the above equation in a dynamic money demand equation for real narrow
money to specw and estimate of an ECM which is discussed in the next section.
The estimated equation for the real broad money is:
69
The equation (5.4) shows the long nm estimated parameters of the real broad money demand
hction. In the long nin, real exchange rate significantly affects the demand for real broad
money in Bangladesh. Red bmaû money and r d exchange rate tmck each other over time
even though there may be deviations h m the long nin path, they only last for a finite tirne.
Lagged values of the error term of this equation appears as the error correction tenn in the
ECM for real broad money which is developed in the next section.
5.3 Error correction modelling
Empirical research on rnoney demand to capture short nin dynamics around its long nui
equilibnum has grown enormously with the introduction of enor correction approach. A
large number of shidies were undertaken over the last decade. Remarkable studies include,
among others, Hall e t al (1989). Muscatefi (1989), Hendry and Ericsson (1991). Boughton
(1991) and Arize (1993). Most of these studies dealt with developed economies. However,
some studies included developing countries as weli. Unfomuiately the studies on developing
cotxntries did not explicitly introduce the degree of monetization and exchange rate variables
which could impact significantly on the demand for money as they are important in the
context of financial reforms that these coutries are undertaking.
Specification and estimation of ECM mode1 for real narrow money in
Bangladesh
Unit mot tests and cointegration tests in the study suggest that log of real narrow money is
70
cointegrated ody with log of real per capita income. Hence, an enror correction model of
demand for the real n m w money in Bangladesh is specified as follows:
where ml is the red narrow money and rpy is the real p a capita GDP, and error correction
term EC is the deviation of observed values of real narrow money fkom its long run
equilibrium path.
According to Hendry and Ericsson's (1991) estimation procedure, a sufncient number of
lagged variables should be included in the ECM to ensure that the residual tems are i.i.d
random variables, i. e., the error tems are white noise. However, only two-period lagged
values are included in the present mode1 for fear of losing the degrees of fieedom. The
estimated model is presented in table 5.9.
The table shows that the error correction temi significantly explains the short run dynamics
in real narrow money. Sign of the error correction tenn is also negative as expected. It means
the change in the value of log of real n m w money depends inversely on the past error
(deviation of actual value fiom its long nin equilibrium path). Other coefficients which are
not significant at the 5% level are dificult to interpret as they represent the diffmnt dynamic
deviations in growth levels. The R2value indicates that the model shows a very good fit-
71
99% ofthe variation in the dependent variable was explained by the explanatory variables.
Table 5.9: OLS estimation of error correction mode1 of real narrow money
Explanatory
variable
Estimated
coefficient
R2 = 0.993
Akaike's FPE= .O191
Standard
error
adjusted R2 = 0.991
AIC= .O186
T-ratio
P-value
D W = 1.24
SC=.0264
VNR= 1.186
-Jacque- Bera L M test
x2(2)= 1.221
Specification and estimation of ECM model for real broad money in
Bangladesh
Again, cointegration tests on broad money suggest that log of real broad money is
cointegrated with real exchange rate. Hence an ermr correction model for real broad money
is specified as follows:
where mi2 is the real broad money and rq is the real exchange rate, and the error correction
tenn is the deviation of observed values of real broad money nom its long nui equilibrium
path. Table 5.10 reports the results.
The table shows that error correction
term is significant and negative as expected in
explaining the short nm dynamics in real bmad money. Note that any loss of Somation due
to differencing the variables is comected by the error correction term. Change in real
exchange rate is also signincant in explaining the short run dynarnics of real broad money.
Other coefficients which are not signincant at the 5% level are difficult to intexpret as
mentioned eariier,
The data fits the mode1 quite well as judged by the value of R2;99 percent of the variation
in the rate of change in real broad money is explained by the explanatory variables included.
The DW statistic suggests that the mode1 has no serious auto-correlation problem. A
comparison of Akaike information criterion (AIC) and Schwarz critenon (SC) between real
narrow money and reai broad money suggests that broad money performs better as it
minimizes the value of AIC and SC. Sequential Chow test for b o t . models were per£ormed
(see table 5.1 1). Real broad money function has only one signincant break point while the
real narrow money has two significant break points. Again broad money function performs
better than narrow money function.
Table 5.10: OLS estimation of error correction mode1 of reaI broad monev
Explanatory
variabIe
Ect-1
Alogrm2t-1
mP.Qt-2
mt
Estimated
coefficient
Standard
P-value
T-ratio
errOr
-1.O45
.O 16
-63.162
.O00
0.005
-017
0.293
.773
0.0003
.O16
0.023
.981
0.010
.O10
0.935
.364
&%t
-0.034
.O10
-3.397
.O04
Ar%-2
-0,019
.O08
-2.265
.O38
6.45 1
.111
57.995
.O00
Constant
Rz=.998
adjusted RZ=.997
D W = 1-78
SC= .O093
Akaike's FPE= .O061
AIC= .O061
VNR-1.186
Jacque Bera LM test x2(2)= 2.053
Table 5.1 1: Chow test coaducted sequentially on error correction modeis of real narrow
money and real broad money.
-
-
--
F-statistic for real
narrow money
Note: denotes significant at the 10%level.
F-statistic for real
broad money
74
We conclude this chapter by noting that, although partial adjutment approach and error
correction approach give the same conclusion in some cases, the resuIts based on these two
approaches are not comparable. Both partial adjustment and error correction approaches have
their own me&
and d&ts.
While partiai adjustment approach takes the level of a variable
as the dependent variable, error correction approach takes the fiirst difference of that variable
as the dependent variable. Hence the interpretations of the individual coefficients of one
model are different h m those of the other. To capture the cornplex dynamic mechanisrn, a
partial adjustment model includes oniy lagged value of the dependent variable while an error
correction model captures short run dynamics around the long run equilibrium and uses
information fiom the data generating process. We can interpret each coefficient of the partial
adjustment mode1 but it is difficult to interpret each coefficient in the error correction model.
So for policy formulation we c m not completely ignore the traditional approach of partial
adjustrnent.
CHAPTER 6
SUMMARY AND CONCLUSION
The main purpose of this study has been to specify and estimate both the narrow money and
the broad money demand fünction in Bangladesh including some non-traditional scaie and
explanatory variables. This is accomplished in two different ways: the traditional partial
adjustment approach and modem error correction approach. The serious problem in
conducting empixical study on a developing cotmûy Like Bangladesh is the quality and
availabiiity of &ta For that reason, one must be carefid in drawing conclusions and use the
results for implementing policy meastues.
Partial adjustment models estimated in the study suggest that both real nanow money and
real broad money follow a partial adjustment mechanism. However, achial money stock
adjusts to desired stock almost instantly. Real per capita GDP and degree of monetization
have positive significant effects on the real narrow money demand in Bangladesh which
indicate that with an increase in real per capita GDP and degree of monetization, demand for
real narrow money increases. Results show that demand for broad money is income elastic.
With high income elasticity, demand for money rises at a faster rate than income. The
coefficient of degree of monetkation is also elastic. In view of the curent financial
liberalizaîion in Bangladesh this finding could be useful.
76
Conflicting evidence is found regarding the role of interest rate in Bangladesh. In the case
of narrow money it is signincant while in the case of broad money it is insignificant. This
supports the interest rate controversy in specifying a money demand mode1 in developing
countnes. This finding also indicates that the role of interest rate on demand for money
depends on the choice of definition of money.
Estimated coefficients of exchange rate fkom the partial adjustment models show that
exchange rate has a positive and signincant eEect on the demand for both narrow money and
broad money. Consequently, any revaluation of the Taka wilI create disequilibnum in the
money market if money supply is not adjusted accordingly. The hding that currency
substitution is greater than asset substitution is a reflection of the less developed
characteristics of financial sector in Bangladesh.
The goodness of fit, as judged by the R2 values of the partial adjustment models of both
narrow money and broad money, suggest that the dernand Eunction for real broad money has
more explanatory power than real narrow money.
From the post sample forecasts, it might be concluded that the broad money demand fiuiction
forecasts better than the narrow money demand h c t i o n as judged by the values of RMSPE
and M M E statistics. In each case, performance of broad money is better than real narrow
rnoney.
77
From Chow test conducted sequentially, it is observed that parameters are significantly
changing in every time period for the real n m w money demand fiinction . However,
parameters of real broad rnoney demand h c t i o n are relatively more stable. As Bangladesh
was going through a process of rapid structural change in the eariy 1980s, it is weli reflected
in the broad money demand hction.
Time series propeaies of the variables related to money dernand are provided by unit root
tests. Unit root tests suggest that ail the variables that are used in the partial adjustment
mode1 are nonstationary and are integrated of order 1. Cointegration tests suggest that real
money is not cointegrated with the variables in the partial adjustment model. Thus, the !mg
run relationship found fiom the partial adjustment model might not represent equilibrium
relationship fiom the cointegration theory point of view. Hence any long nm policy measure
based on the partial adjustment model might not be effective.
Cointegration tests also show that real narrow money is cointegrated with real per capita
GDP.Hence equilibrhm long run relatiomhip exists between these two variables which c m
be used for policy formulation. Estimation of cointegrating vector suggests that real per
capita income has a positive significant effect on demand for real narrow money which
supports the transaction approach to money demand.
On the other hand, real broad money is cointegrated with real exchange rate. It indicates that
an equilibriurn long nui relationship exists between real broad money and real exchange rate.
78
Over the last decade Bangladesh has been progressing toward trade liberaluation rapidly.
Furtber, manpower export nom Bangladesh has increased tremendously. This fact has
shifted the emphasis nom traditional explanatory variables to exchange rate.
Error correction modelling suggested that short nin dynamics in the rcal money (Alogrml
and Alogrm2) are significantly affectecl by the error correction t e m ~(deviation of actual
value from its long run oquilibrium path) as expected. Thus a proportion of the
disequilibrium nom one period is corrected in the next period.
The hdiugs of the study have some policy implications for Bangladesh. As money demand
fhction shows the economy's capacity to absorb money supply, if the supply of money is
greater than its demanâ, the economy wili experience infiationary pressure. Similarly, if
money supply is less than the demand for money, an economy is likely to expenence
deflationary pressure. The values of the estimated adjustment coefficients in the study
suggest that the money supply has to be changed very fast to maintain equilibrium in the
money market. Further, with the improvement of economic condition, measured by per
capita income, demand for money is expected to increase and hence, money supply has also
to be increased to maintain equilibrium.
Since interest rate is formd to be insignincant in explaining movements of real broad money
in Bangladesh, it suggests that for effective monetary policy, interest rate should be allowed
to be d e t e d e d by the fke market forces. Sirice, the degree of monetization has a positive
79
effect on money demanci, the policy makers should take note that increases in the degree of
monetization lead to increases in money dernand. Hence money supply has to be increased
to maintain a stable interest rate.
Since cointegration tests and estimation of cointegrating vector show that, in the long run,
real per capita income has a positive effêct on real narrow money and exchange rate has a
positive effect on real broad money, long temi planning should take this into consideration.
Monetary authorities should increase the money supply with an increase in per capita income
to maintain equilibrium. Similady, they shouid also be aware of the fact that any devaluation
or appreciation in the exchange rate is likely to affect the demand for money and hence
appropnate measures should be taken accordingly.
Above dl, if primary goal of Bangladesh Bank i s to choose the proper definition of money
which yields i) better goodness of fit ii) relatively accurate predictive power and 5)more
stable parameters the broad money should be, undoubtedly, a better choice than the narrow
money.
APPENDGY: A
The Data Set
YR
CPI
INT
FX
GDP
PN
Ml
M2
Description of the variables:
YR:Year
CPI: Consumer %ce Index (1WO=I 00).
INT:Discount rate (end ofperiod) is measured in percent per mum.
FX: Exchange Rate (end of period) is in Taka per US$.
GDP: Gross Domestic Product are in biiiions of Taka.
PN:Population (rnidyear estimates) are in millions.
Ml :Narrow Money in millions of Taka
M2:Broad Money in millions of Taka.
APPENDIX B: FIGURES
Millions of Taka
Fig. 1:Levels of M l and M2
Fig. 2: LeveIs of exchange rate (q) and interest rate (r)
O
,
I
I
3
74757677787980818283848586878889909192939495
GDP
--
Year
dm
Fig. 3: Levels of Gross Domestic Product (GDP)and degree of monetization (dm).
Percent
0.25
O
:
a
,
;
l
,
t
:
:
i
!
'
8
.
!
I
i
74757677787980818283848586878889909192939495
inf
Fig. 4: Levels of inflation rate (inf).
Year
Percent
Fig. 5: First differences of log of real M l (Irml) and log of real M2 (lrrn2).
Percent
Fig. 6: First differences of log of real per capita GDP Orpy) and log of degree of
monetization (Idm).
Percent
Year
ri
--
rq
Fig. 7: First dmerences of real interest rate (ri) and real exchange rate (rq).
Percent
I
7576777879808182838485868788899091B293949596
Year
inf
Fig. 8: First difSerences of innation rate (inf).
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