Information about Asia and the Pacific Asia y el Pacífico
Chapter

Appendix III. Individual Country Results

Author(s):
Robert Corker, and Wanda Tseng
Published Date:
March 1991
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Indonesia

Satisfactory equations can be estimated for both narrow and broad monetary aggregates, and these equations appear to have been stable in the 1980s. However, the broad money equation is only stable after taking into account certain aspects of structural change in the 1980s. Specifically, the opportunity cost variable in this equation needs to be adjusted to reflect the rising share of quasi-money in broad money in the 1980s, which raised the average interest paid on monetary assets. And a onetime adjustment to the level of broad money holdings appears to have followed the October 1988 package of financial liberalization measures.

The velocity of narrow money is approximately a stationary time series over the complete sample period. 1970–89, but not over the subperiod 1974–89 for which interest rate data were available. In this latter subperiod, narrow money is, according to the formal statistical tests, cointegrated with income and interest rates, but less formal analysis casts doubt on the stability of the long-run money demand function (Table 1). In particular, the interest rate elasticity is not significant in the subperiod 1974 to the second quarter of 1983 (when substantial financial reforms were introduced). Nevertheless, an error correction model with satisfactory statistical properties was estimated in which the long-run income elasticity was just greater than one (1.16) and deposit rates—rather than expected inflation rates—have a significant negative effect on real money balances.56 Long-run price homogeneity was imposed on the demand function, but the error correction equation allowed for short-run money illusion (Table 2). The error correction equation passed tests for parameter stability, particularly in the periods after the 1983 and 1988 financial liberalization packages.

Real broad money balances appear to be cointegrated with income and a measure of the opportunity cost of holding broad money pointing to the existence of a stable long-run money demand function.57 The long-run income elasticity of real money balances is significantly greater than one (1.58), reflecting the downward trend in velocity over the sample period. An opportunity cost variable consisting of a foreign interest rate (three-month LIBOR) minus a deposit rate weighted by the share of quasi-money in broad money also has a significant effect on broad money demand.58 A decline in the opportunity cost of holding money accounts for some of the acceleration in velocity decline that occurred in the mid-1980s and captures some of the change in the structure of broad money in the 1980s (Chart 2). An intercept shift dummy to take account of the effects of the October 1988 financial liberalization package was also found to have a significant positive effect on the long-run level of money demand: no similar effect could be found for the June 1983 liberalization package. A statistically satisfactory error correction model was estimated that passed parameter stability tests over a wide range of subperiods (Table 3). Short-run price homogeneity was imposed on money demand in the error correction model; long-run price homogeneity of broad money demand is supported by the data.

Korea

Only a stable relationship explaining demand for broad money could be found as the demand for narrow money does not appear to be cointegrated with income or interest rates. The stability of the demand-for-broad-money relationship rests with the inclusion of a variable that measures the steady decline in the opportunity cost of holding money in the 1970s and 1980s. This variable captures some elements of structural changes in the Korean financial system during these decades, in particular the declining importance of curb markets.

Narrow money is not cointegrated with income and interest rates (or expected inflation rates) implying that no stable long-run money demand function exists for narrow money (Table 1). In particular, the sharp, temporary, increase in the income velocity of narrow money during the early 1980s cannot be satisfactorily explained.

Broad money (M2) appears to be cointegrated with income and a measure of the opportunity cost of holding money, although the evidence is not strong (Table 1).59 The unrestricted estimates of the long-run elasticities support homogeneity between broad money, income, and prices: in the long run, income velocity is a constant determined by the level of interest rates. The opportunity cost term consists of the interest rate in the curb market minus deposit rates weighted by the share of quasi-money in broad money. The large positive gap between curb market and deposit rates declined steadily during the last two decades, partly because financial deregulation encouraged the development of the official financial sector. The opportunity cost variable, therefore, explains the downtrend in income velocity in that period.60

A satisfactory error correction model can be estimated for broad money over the period 1970–89 with changes in real income helping to predict deviations from long-run equilibrium (Table 3). The equation passes tests for parameter stability over diverse subsamples; however, in the 1980s sub-period, the coefficient on the error correction term is somewhat smaller and less significant and there is evidence of residual autocorrelation.61 This result may indicate some degree of structural change in the 1980s—for example, the development of the formal nonbank financial sector—that cannot be explained by the opportunity cost variable alone. Indeed, as the curb market continues to decline in importance, the interest rates in that market may not reflect the return on alternative investments in Korea suggesting that a reappraisal of the money demand function using alternative measures of the opportunity cost of holding money will be warranted in the future.

Malaysia

Despite its greater volatility, narrow money has been at least as stable and predictable a variable as broad money. Indeed, the evidence for the existence of a stable money demand equation is much more compelling for narrow money than for broad money. The income elasticity of broad money is substantially greater than one.

The income velocity of narrow money is a stationary series (it is integrated of order zero), although the freely estimated long-run income elasticity is a little greater than unity (Table 1). This appears to be a cointegrated relationship and, therefore, a valid long-run demand function. No long-run effects on money demand could be found for interest rates (several interest rate variables, including foreign rates, were tested) or expected inflation.62 A satisfactory error correction model can be estimated that has reasonably stable parameters in the 1980s (Table 2).

The evidence that broad money is cointegrated with income and interest rates is somewhat weak, casting doubt on the existence of a long-run money demand function. The estimated long-run income elasticity substantially exceeds one (1.63) and the long-run semielasticity of interest rates is also quite large (Table 1). The interest rate variable—an opportunity cost term equal to the three-month LIBOR minus deposit rates weighted by the share of quasi-money in broad money—can only account for part of the trend decline in the income velocity of broad money. A satisfactory and stable error correction model was estimated (Table 3).

Myanmar

Narrow and broad monetary aggregates did not behave very predictably in the 1970s and 1980s. If allowance is made for the demonetization of September 1987, narrow money appears to be cointegrated with income, but medium-term income velocity trends have fluctuated substantially, and short-run movements in money demand are not very predictable.63 Broad money does not appear to be related in a stable fashion to income or inflation rates, even after making allowance for the demonetization episodes of the late 1980s. The effects on money demand of the reforms introduced at the end of the decade are too recent to be analyzed in detail.

Real narrow money balances appear to be coin-tegrated with real income, after allowing for a onetime decrease in money holdings following the September 1987 demonetization, indicating the existence of a stable long-run relationship (Table 1).64 However, the long-run income elasticity of narrow money demand was estimated at close to two in the 1980s compared with less than one in the 1970s indicating that the medium-term behavior of narrow money has fluctuated quite widely. No role for interest rates (which changed only once in the sample period) or inflation rates could be found. An estimated error correction model of narrow money demand exhibited residual serial correlation and did not have stable coefficients (Table 2).

No stable long-run broad money relationship appears to exist as broad money is not Cointegrated with income and inflation rates, even after allowing for the effects of the 1985 and 1987 demonetizations. The result reflects the changing trends in velocity over the 1970s and 1980s: in the first half of the 1970s, velocity tended to rise before trending down between the mid-1970s and the period of financial turbulence in the last half of the 1980s (Chart 2).

Nepal

Narrow money and income may be related in a stable fashion in the long run but, partly because of data limitations, short-run money demand is not very predictable. The long-run broad money/income relationship was not stable, reflecting a slowdown in the trend decline in velocity during the 1980s from the extremely rapid rate of the 1970s. It is too early to judge the impact on money demand of the deregulation of interest rates in August 1989.

Real narrow money balances are possibly cointegrated—not all the statistical tests are satisfied—with real income (Table 1). No long-run role could be found for interest rates, which changed infrequently over the course of the data sample, or for inflation rates. The income elasticity was estimated at 1.8 using the entire sample, although there is evidence that the elasticity declined somewhat in the 1980s, suggesting a deceleration of the rapid process of monetization. No satisfactory error correction model was estimated, although this may reflect the time series interpolation of the quarterly income series from annual observations. The best error correction equation exhibited significant residual autocorrelation (Table 2).

Real broad money balances were not cointegrated with income and interest or inflation rates over the period 1970–89 (Table 1). This result reflects a substantial deceleration in the decline of velocity in this period: in the 1970s, the freely estimated income elasticity exceeds three, while in the 1980s, the elasticity is just below two.

Philippines

It is possible that both narrow and broad monetary aggregates bear stable long-run relationships to income and interest rates, although the stability of the narrow money relationship relies on an ad hoc adjustment for financial turbulence in the mid-1980s. No satisfactory error correction equation could be estimated for either aggregate.

Narrow money is not cointegrated with income and interest or inflation rates unless allowance is made for a structural break in the mid-1980s. Specifically, an intercept shift dummy variable is required from end-1983 onward to produce a long-run money demand function that is close to satisfying the cointegration tests (Table 1).65 The income elasticity is 0.67 and a significant negative role is found for deposit rates.66 A reasonable error correction model can be estimated for narrow money if money illusion is permitted in the short run: long-run price homogeneity is imposed. The equation’s parameters are not stable, however, suggesting that it is not possible to explain the high degree of velocity volatility in the 1980s and, in particular, the “spike” in velocity in the mid-1980s.

By contrast, real broad money balances appear to be cointegrated with income without need for an intercept shift variable in the 1980s (Table 1). However, no long-run role could be found for various interest rate and opportunity cost variables. The estimated long-run income elasticity is 1.47, considerably larger than Goldsbrough and Zaidi’s (1989) estimate of 0.8. The estimated error correction equation—which includes short-run interest rate effects—exhibited signs of residual autocorrelation, and the size of the coefficient on the error correction term increased significantly in the 1980s. Even allowing for this via a dummy variable to capture a different pace of adjustment in the period of financial instability, the equation failed formal parameter stability tests.

Singapore

Although Singapore did not undertake major financial liberalization measures in the 1980s—its financial markets were already well developed and external capital flows liberalized before the beginning of that decade—it proved difficult to find stable, predictable money demand relationships. Neither narrow nor broad money was cointegrated with income and interest rates alone. The narrow aggregate may be cointegrated with income, interest rates, and the expected appreciation of the Singapore dollar. However, no satisfactory error correction model could be found.

Narrow money appears to be cointegrated with income, interest (deposit), and exchange rates, suggesting the existence of a stable long-run money demand function (Table 1), The exchange rate term is the one-period-ahead change in the value of the Singapore dollar in terms of U.S. dollars and has a positive coefficient: expected appreciations imply a rise in the demand for narrow money. The income elasticity is just less than one (0.86), implying some economizing on money holdings by agents commensurate with the relatively sophisticated state of Singapore’s financial markets. Without the exchange rate term, narrow money does not appear to be cointegrated with income and interest rates, or income and inflation rates. It was not possible to estimate a satisfactory error correction model of narrow money—in all specifications tried, the error correction term was not statistically significant—possibly because short-run expectations about exchange rate movements are not systematically related to the observable macro-economic indicators.

Broad money does not appear to be cointegrated with income and interest rates. A number of variants were tried, including different interest rates (foreign and domestic), inflation rate proxies for the opportunity cost of money, and expected changes in the exchange rate. None was successful, nor were attempts to allow for a structural break between the 1970s and 1980s using dummy variable techniques. The freely estimated income elasticities greatly exceeded one, possibly reflecting strong wealth effects on the demand for money.

Sri Lanka

Broad money appears to be the most reliable monetary aggregate and there is evidence that it behaved reasonably predictably in the 1980s despile major disruptions to the economy. Narrow money does not appear to be related in a stable way to income and interest rates.

Reflecting the wide fluctuations in velocity over the last two decades, narrow money was not cointegrated with income and interest or inflation rates, although tests of the effects of interest rates on money demand were confined to a relatively short period (1978–89) because of the constraints on data availability. In particular, developments in income, interest rates, and inflation cannot explain the reversal of the upward trend in velocity in 1984. Instead, the income elasticity increases significantly in the second” half of the 1980s. The change in the velocity trend possibly reflects a portfolio shift to more liquid assets following the onset of political turbulence in Sri Lanka.

Broad money may be cointegrated with income and interest rates, but the evidence is not strong (Table 1). The income elasticity is about 1.2 and the interest rate—deposit rates weighted by the share of quasi-money in broad money—elasticity is positive. Other interest rate variables, including the secondary market treasury bill rate and money market rates, had negative, but statistically insignificant effects on money demand. This may reflect either insufficient observations, or problems in measuring market returns on alternative assets. A satisfactory error correction model was estimated and had stable coefficients in the last half of the 1980s.

Thailand

Stable long-run relationships could not be found for either narrow or broad money. There is some evidence that relative asset returns—as opposed to the general level of interest rates—affect broad money.

Narrow money does not appear to bear a stable long-run relationship to income and interest or inflation rates (Table 1). While the income elasticity is close to one (0.85) and deposit interest rates have a significant negative long-run effect on narrow money, this relationship does not pass the tests for cointegration. No short-run dynamic model of narrow money demand was estimated.67

The estimated income elasticity of broad money greatly exceeded one (1–72), money market rates were found to have a negative effect on broad money demand, and an estimate of the average return on broad money had the expected positive effect. The interest rate terms can be combined in an opportunity cost variable with a semielasticity of 2.5, suggesting that differences in rates of returns on assets—as opposed to the general level of interest rates in the economy—affect money demand. However, broad money, income, and the opportunity cost variable do not appear to be cointegrated, implying the absence of a stable long-run relationship. This result may reflect the comparatively short sample period (1977–89) during which interest rates were not fully flexible.

References

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South-East Asian Central Banks (SEACEN) Research and Training Center (1979). Throughout this paper, the term “Asian countries” refers to the member countries of the SEACEN: Indonesia, Korea, Malaysia, Myanmar, Nepal, the Philippines, Singapore, Sri Lanka, and Thailand.

World Bank (1989), pp. 27–32.

The real interest rate is measured by the nominal interest rate minus the change in the consumer price index over the past 12 months. This assumes that inflation expectations can be approximated by actual inflation over the past 12 months.

In the first demonetization, on November 3. 1985, K 50 and K 100 currency notes, amounting to 46 percent of the currency in circulation, were demonetized. New currency notes of K 75 were introduced from November 11. 1985 and K 15 and K 35 notes from August 1, 1986. The second demonetization was carrieci out on September 5, 1987. All higher-denominated notes (K 25, K 35, and K 75), accounting for 57 percent of currency in circulation, ceased to be legal tender. New currency notes of K 45 and K 90 were introduced witheffect from September 22, 1987. The purpose of the demonetizations was to uncover illegally derived profits. In the case of the demonetization in November 1985, the surrendered demonetized notes were refunded to the holders after an investigation of sources of income and tax compliance. However, no arrangements were made to make refunds to holders of notes demonetized in September 1987.

Under the liquidity credit scheme, banks provide loans to selected sectors at relatively low interest rates, with the loans eligible for rediscount credits from the central bank at subsidized interest rates. A large proportion of liquidity credits outstanding at the end of March 1983 was made ineligible for renewal.

Further significant changes to the liquidity credit scheme were announced in January 1990, including reductions in the categories and amounts eligible for liquidity credits, as well as increases in rediscount and lending rates.

These exchange rate arrangements correspond to the Internalional Monetary Fund’s categorization of exchange arrangements (see International Financial Statistics). The distinctions between the categories are often difficult to discern in practice, Some countries maintaining pegged arrangements flexibly adjust their pegs, while other countries maintaining flexible arrangements effectively set their exchange rates, albeit adjusting them frequently.

Alternatively, the rapid growth of quasi-money accounted for a downward trend in the income velocity of broad money (income divided by money).

Sce Goldfeld and Sithel (1990) for a summary of theoretical models of money demand.

A complete description of the data used in the analysis can be found in Appendix II.

See Cuthbertson (1988) for one such attempt.

This was the assumption in the earlier SEACEN study, see Aghevli and others (1979).

For further discussion about the long-run solutions of error correction models, see Davidson and others (1978) and Salmon (1982).

See Hendry (1986) and Granger (1986) for further discussion of the main issues involved in this subsection.

The term cointegration derives from nomenclature “order of integration” used to describe the number of times a time series must be first-differenced to render it stationary.

According to Johansen (1988), there may be as many as n-l linear combinations of n data series that are coimegrated, implying that any particular long-run relationship may not be unique. In practice, theoretical priors, as well as statistical criteria, are used to choose among the possible long-run relationships.

Boughton (1990) provides some examples to illustrate this point.

This procedure is often described as general-to-specific modeling (see Hendry and Mizon (1978)). Only a fairly low order of lag (n=2 in equation (2)) was assumed in the initial specification used here.

Sce Lucas (1988) for a discussion of the theoretical condi tions for money demand to be stable.

The tests are said to have low statistical power in these circumstances. See Engle and Granger (1987) for more details.

This result contrasts with the findings of Blundell-Wignall and others (1990), who find little evidence of long-run relationships between money and income in selected industrial countries.

Price homogeneity (a1 = 1) was imposed when estimating the long-run money demand functions even though, in some cases, the restriction was not supported by the data.

Conlrasl with Aghevli and others (1979) in which inflation was used to proxy the opportunity cost of money.

Compare with the explanation for the trend decline in the velocity of broad money in Japan offered in Corker (1990).

A similar dummy variable was also used by Goldsbrough and Zaidi (1989) in their analysis of money demand in the Philippines.

For the sample as a whole, inflation rates and velocity movements are not well correlated, although this result may reflect inappropriate treatment of expectations.

For some of the equations in Tables 2 and 3, the dependent variable is the change in nominal money balances, while for others it is the change in real money balances. The choice was based largely on econometric criteria. Where nominal money is the dependent variable, the equation implies some degree of “money illusion” in the short run. However, in the long run, the error correction term ensures that money is homogenous of degree one in prices.

Although, as noted above, the effects of the 1988 package were assumed to have had a onetime impact on the level of long-run broad money holdings.

McKinnon (1973) and Shaw (1973) have pointed out that restrictive monetary policy effected by raising interest rates may not be contractionary because, in financially repressed markets, higher interest rates induce more savings which, in turn, increase the supply of credit available for the financing of investment and/or working capital. This analysis, however, has been challenged by the “neo-structuralists” associated with Taylor (1981). The neo-structuralists questioned the validity of the savings effect and cited structural impediments to higher investment (e.g., the dominance of public investment, foreign exchange constraints, and inefficient financial intermediation) even if higher savings were forthcoming.

See Frenkel and Johnson (1976) and International Monetary Fund (1977) for a discussion on the monetary approach to the balance of payments.

This view was proposed by Poole (1970) in the context of a closed economy model, but has been extended, with qualifications, to open economy models by, for example, Bryant (1980) and Benavie (1983).

Goldsb rough and Zaidi (1989). If such inflows occurred and did not reflect an unanticipated increase in the demand for money and if the central bank intervened in the exchange market to offset part of the upward pressures on the exchange rate, then the impact on the money supply and prices could be substantial unless the intervention was sterilized.

Myanmar, Nepal, and Singapore are not covered. Myanmar does not use indirect instruments but implements an annual credit plan in the context of central planning. Nepal did not rely on indirect instruments during most of the 1980s; financial reforms, including the introduction of indirect monetary instruments, were introduced in 1988/89 but the time period is too short to permit analysis of the effects of these instruments. Singapore does not implement an independent monetary polity because the exchange rate has the primary role in stabilization.

For a summary of the reasons (or high real interest rates in the Southern Cone countries, see Cho and Khatkhate (1989).

The money multiplier can be expressed as m = (c + 1)/(c + r) where c denotes the currency (outside banks)-to-deposits ratio and r denotes the banks’ reserves-lo-dcposits ratio. Increases in interest rates tend to reduce the public’s currency-to-deposits ratio and reductions in reserve requirements lower banks’ reserve-to-deposits ratio; both increase the money multiplier.

For example, in Malaysia, the Philippines, and Sri Lanka, data on “net claims on government” include government deposits with the central bank associated with the sales of treasury bills for monetary control purposes.

The new indirect instruments were open market operations (with central bank debt certificates—the Sertifical Bank Indonesia or SBI) complemented by a system of new general rediscount facilities.

The automatic rcdiscounting of money market paper by the central bank was replaced by daily auctions of central bank debt instruments to inject or withdraw liquidity.

The October 1988 policy package included measures to promote secondary trading in money market securities.

In October 1988, the minimum liquidity requirement for banks was reduced from 15 percent to 2 percent of deposit liabilities and the latter rate was also made applicable to non-bank financial institutions.

The reserve requirements were gradually reduced from 20–27 percent in the late 1970s to 4½ percent in 1984.

From 1984 until late 1986, these operations had been largely conducted through the purchase and sale of the Central Bank’s own securities. Toward the end of 1986, the sale of new central bank bills was suspended and replaced by additional sales of treasury securities with proceeds deposited at the Central Bank. By the end of 1987, all central bank bills had been withdrawn, except for a very small amount: some longer-term central bank securities, including central bank certificates of indebtedness also remain. These central bank operations were supplemented by open market operations involving short-term purchases or sale of the Central Bank’s own stock of treasury securities (repurchase arrangements (RPs) and reverse repurchase arrangements, respectively).

The increases in net other items were associated with losses on the Central Bank’s forward cover and foreign exchange swap operations and net interest payments on the Central Bank’s domestic and foreign liabilities.

The treasury bill auctions replaced the monthly auctions of central bank securities, which had been in effect during 1984–86, as the primary vehicle for open market operations. The use of central bank securities has been largely discontinued, although there have been small issues from time to time.

Until July 1987, the Central Bank applied varying reserve requirements on different lypes of deposits: the average (weighted) reserve requirement was 12 percent of total bank deposits. The required reserve ratios were unified and reduced to 10 percent in August 1987.

A number of supporting measures were also implemented, including increases in the Central Bank’s discount rates and the reimposition of selective credit controls.

Open-markel-type operations in the repurchase market for government bonds were established in April 1979. In May 1987, these were supplemented by the issuance of central bank bonds.

The amount of refinancing by the central bank was reduced from 100 percent to 50 percent of the face value of the qualifying notes.

Alternatives to the standard definitions of the monetary aggregates (usually M1 or M2) have been constructed for some of the countries analyzed here. For example, in Korea, the authorities have constructed an alternative to M2, called M2B, which includes some nonbank liabilities (see Kim and others (1990)). In Malaysia, repurchase agreements have recently been added to the definition of M2.

Tests for the order of integration were applied to, with the exception of interest rates, the logarithm of the series.

The return on foreign assets should also include the expected depreciation of the exchange rate and/or a risk premium. In practice, the analysis here assumed that exchange rates follow a random walk—that is, the expected depreciation is zero—and risk premiums have been constant in history. Tests of these assumptions were carried out in certain cases.

Because the power of the tests for cointegralion are biased toward rejecting cointegration in marginal cases, error correction models were estimated for the borderline cases in which non-cointegration could he rejected at around the 10 percent significance level as opposed to the usual 5 percent significance level.

Strictly speaking, the tests reject non-cointegration.

Domestic interest rate variables appear to have played a less important role in money demand, perhaps because the thinness of domestic money markets in much of the sample period contributed to erratic movements in market-determined interest rates. No role could be found for separate exchange rate expectations variables, particularly around the large rupiah devaluations in 1978, 1983, and 1986.

The long-run relalionship just fails the ADF test, but passes the DF test, at the 5 percent level.

Without this term, the income elasticity of broad money exceeds one, agreeing with other published estimates (see, for example. Park (1989)).

Goodfriend (1985) notes that measurement error may bias the estimation of the coefficient on the error correction term toward zero.

The failure to find significant foreign interest rate effects may reflect an inability to account for a possibly changing foreign exchange rate premium.

Some of the unpredictability may be due to the poor quality of the data. In particular, quarterly GDP data are interpolated from annual data using time series methods.

A significant onetime increase in money holdings following the November 1985 demonetization was disregarded.

The dummy variable was suggested by the work of Goldsbrough and Zaidi (1989).

The result is a little lower than the long-run income elasticity of 0.8 estimated by Goldsbrough and Zaidi (1989).

Because GDP data were interpolated from annual data by time series methods, a high degree of confidence would not be attached to any short-run model of money demand.

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