A Demand for Money Function with Output Uncertainty, Monetary Volatility, and Financial Innovations: Evidence from Japan

Abstract

The impact of monetary policy is essentially determined by the stability of the money demand function. Inclusion of financial innovation as a variable led to a more explanatory model which was unable to predict the future. When the inadequacy of partial adjustment modeling framework is adjusted, the model faces empirical difficulties. Considering instability of money demand is an omitted variable problem, this paper employs Vector Error Correction Method to solve that problem. Output volatility, monetary volatility and financial service are included in the model besides real output and nominal interest rate. Based on augmented Dicky-Fuller tests and cointegration tests, long run stability of money demand function is established. The Vector Error Correction Model yields conventionally expected and statistically significant results for all variables. Variance decomposition and impulse response show an increasing effect of monetary volatility, output uncertainty and financial services. On the other hand, interest rate and real GDP show declining effect. Innovations in financial service, output volatility and monetary volatility are vital in explaining money demand.