Assignment on Money Demand Function in Bangladesh-Analysis of the annual time series data (1977-2003)

In most macroeconomic theories, the relation between demand for money balances and it’s determinates is a fundamental building block. And yet most macroeconomic models, Whether theoretical or economical, generally ignore the rich institutional detail of financial sector and attempt to capture financial factors via the demand and supply of money. A well-defined and stable money demand function is a necessary condition for monetary policy to have predictable effect on the macroeconomic variables. Therefore, the demand for money has been studied extensively both in the developed and under developed countries.
1.A Literature Review :
In this paper an attempt has been made to estimate money demand function for Bangladesh using time series data from 1977 to 2003. Several attempts have so far been made to estimate money demand function for Bangladesh. While Ahmed (1977), Murty and Murty (1978) Hossain (1988) have estimated money demand function by using annual time series data. Using linear and log linear specifications of the money demand function, Ahmed (1977) found that the demand for morrow money (M1) was positively related to the income and negatively related to interest rate. Murty and murty (1978) using Ahmed (1977) data sets and Box-cox (1964) technique, found similar relationship between money, income and interest rate. They both used the same annual time series data for 1959/60-1975/76 (excluding two years 1970-71 and 1971-72). Thus comprising to the both pre and post liberation periods, others have considered the post liberation period only.

Taslim (1983) introduced expected inflation rate as a measure of opportunity cost of holding money in stead of using nominal interest rate that was significant. He criticized using of nominal interest rate as an explanatory variable. This is because it was determined by institutional settings rather than market forces.

Hossain (1988) studied the stability of demand for money function in Bangladesh. He found real income; expected rate of interest rate; expected rate of inflation were major determinates of money demand function in Bangladesh. Using chow and CUSUM and CUSUMS’Q test, he found stable broad money function while he identified the instability of narrow money demand function. He also mentioned the nominal interest rate may provide inconclusive result for money demand in least developed countries. The latest attempt in studying money demand is Islam (2000) who employed sophisticated econometric techniques, Johansen-Jusetius co-integration tests, in estimation of money demand function, in Bangladesh using quarterly data set only for 1974 Q1-1996,Q4. He found that nominal interest rate plays an insignificant role for broad money which might has been caused by institutional setting of interest rate.

So, from the empirical studies in the context of Bangladesh provide conclusive evidence that real income and expected inflation rate but inconclusive evidence regarding the significance of interest rate.

In this paper an attempt has been made to estimate money demand function for Bangladesh that exists a valid long run relationship among monetary aggregates, real income, expected weighted interest rate and expected inflation rate.

2. Specification of the Model
The Specification of the econometric model will be based on economic theory. This theory indicates the general factors which affect the dependent variable in particular case. In this paper, it is attempted to estimate the money demand function for Bangladesh on the basis of keynensian money demand function. Keynes diagnosed three possible motives for holding money –

1.Transaction motive;
Precautionary Motive,
Speculative Motive.
To the extent that the volume of transactions rises with income, both transactions and precautionary demand for real balances rise with an increase in income. The speculative demand for real balances reduces with the rise in the opportunity costs of holding money.

To estimate the “Money Demand” function for Bangladesh, variables normally included here, are scale variable such as real GDP, interest rate and expected inflation. The real G.D.P is used for determinant of money demand function because it captures the transactions and precautionary motives for holding money and the interest rate and expected inflation capture the speculative motive. Actually the last two determinants act as an opportunity costs of holding money.
On the basis of this information, the Long run money demand function for Bangladesh takes the following functional form –