MODELLING MONEY DEMAND IN OPEN ECONOMIES : THE CASE OF SELECTED ASIAN COUNTRIES

Abstract

While early works on the demand for money focused primarily on the importance of domestic economic variables on money demand behaviour, many recent papers have added a new dimension to the topic by suggesting that foreign variables also influence domestic money demand behaviour in an open economy. Using a general portfolio balance model, this thesis examines the importance of such foreign variables in explaining money demand behaviour in four Asian countries, namely Singapore, Japan, the Philippines and South Korea. In particular an attempt is made to establish the significance of the phenomena of currency substitution and capital mobility in these countries.

The econometric model adopted in this empirical study is the error­ correction model (ECM) which has the special property of being able to separate the long-run and short-run effects of the explanatory variables on the regressands. Surprisingly, despite the many advantages that ECMs offer over conventional time-series modelling techniques, they have up to now been mostly applied to money demand models of developed countries only. Rather disturbing also, is the fact that many of the limited number of related studies which applied this econometric technique have overlooked the fact that the presence of co-integration between the regressand and all or a subset of the regressors is the basic premise for the existence of an error-correction representation. Hence, this thesis will employ an ECM formulation technique which is firmly based on the concept of co­integration so that it will not be subjected to this criticism.

The empirical results support the proposition that at least some open economy variables are important determinants of money demand behaviour (at least in the short run). The results also suggest that money demand behaviour in the most of the countries studied seem to support the monetarist paradigm of money demand where permanent income is the main determinant of money demand in the long-run while both opportunity cost variables and permanent income affect money demand in the short-run.