In this paper a money demand function for the dollarized Paraguayan economy is derived. The focus lies on finding the determinants of currency holdings decisions (Guarani vs. USD). Natural candidate variables for these decisions are the nominal exchange rate and foreign/domestic interest rate spreads. The model established is similar to models used for open economies such as Sriram (1999). The monetary aggregate under surveillance is M2, which in Paraguay represents national currency holdings including all non remunerated money holdings and deposits of all maturities. In line with the use of M2, interest rate spreads between long and short term deposits usually found in money demand models become obsolete. In the analysis a cleaning procedure for M2 is introduced.
Cleaning refers to interests paid by the central bank when offering deposits to commercial banks for reasons of bank money control. These interest earnings are not considered in standard money demand specifications and thus produce a trending behaviour that can lead to misestimates of the income elasticity.
The following results emerge from this study. An index constructed from the foreign/domestic interest spread and the exchange rate is capable of describing characteristic dynamics of the real M2 aggregate. Interest paid by central banks can be an explanation for high income elasticities usually found in money demand studies dealing with developing countries.
The remainder of this paper is structured as follows. Section 2 gives data description and presents intuitive analysis that motivates variable selection and modelling strategy. Section 3 presents the economic theory. Econometric specification, estimating and testing are presented in section 4. Main conclusions are presented in the final section.
Contents
Abstract
1.1 Introduction: money demand in Paraguay
1.2 Data description and variable selection
- 1.2.1 The data
1.2.2 Graphical interpretation and motivation for variable selection
1.3 Economic theory
- 1.3.1 The macroeconomic model
1.3.2 Effects of currency holdings decisions on M2
1.4 Time series properties, estimation and testing 6
- 1.4.1 Time series properties of the data
1.4.2 Cointegration analysis
1.4.3 An error correction model
1.5 Conclusions
References
Appendices
2.1 Introduction: money demand in Peru
2.2 Stylized facts, literature and data
- 2.2.1 Stylized facts and money demand studies
2.2.2 Data and graphical interpretation
2.3 Economic theory
- 2.3.1 The macroeconomic model
2.3.2 The log linear models
2.4 Time series properties, estimation and testing
- 2.4.1 Time series properties of the data
2.4.2 Cointegration analysis
2.4.3 An error correction model
2.4.4 Stability analysis
2.5 Conclusions
References
Appendices
3.1 Introduction: post crisis money demand in Argentina
3.2 Stylized facts, literature and data
- 3.2.1 Stylized facts and money demand studies
3.2.2 Data and graphical interpretation
3.3 Economic theory
- 3.3.1 The macroeconomic model
3.3.2 The log linear model
3.4 Time series properties, estimation and testing 39
- 3.4.1 Time series properties of the data
3.4.2 Cointegration analysis
3.4.3 An error correction model
3.5 Conclusions
References
Appendices
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Money demand in dollarized countries: an empirical investigation
