Money demand stability myth or reality

A developing economy is often vulnerable to fluctuations in growth and inflation, both significant factors related to the demand for money. Changes in money supply, whether policy induced or not, also have a bearing on this relationship. The current transition towards deregulation and market-related rates has raised doubts about the traditional wisdom regarding the role of money demand in the formulation of monetary policy. This study examines this influential, yet highly controversial subject in monetary economics namely, the behaviour of aggregate money demand. The crucial question is whether economic agents adjust to exogenous shocks and whether such shocks have a bearing on the stability of the money demand relationship. Furthermore, it is necessary to examine whether money demand in India is stable enough to be useful for ex-ante prediction and control.

There has been considerable research on this topic in India. But there is not much empirical evidence based on the newer techniques such as cointegration. Thus a comparative evaluation of the various tools of applied economic research as applied to money demand analysis remained a long felt need. A major objective of this study is to make a contribution towards this end.

Based upon alternate theories and models, we investigate money demand behaviour in India from the 'sixties to the 'nineties. In addition to the partial adjustment ecification commonly adopted in conventional applied research, we employ the buffer stock approach and the technique of error correction. Having obtained different empirical models, we evaluate them, focussing on stability and predictability issues that have important implications for monetary management.