Study Of Financial Development In The Demand For Money Activities

The key point in studying a country's money demand activity is to construct the money demand function. The money demand function is the cornerstone of any macroeconomic model and monetary policy, and a stable money demand function is thought to be essential for monetary policy, because it is supposed to play a key role in enabling the monetary authorities to set an intermediate target, money supply, consistent with final targets such as the inflation rate and /or real income, so finding a stable money demand function is generally considered essential for the formulation and conduct of efficient monetary policy. Hence, considerable effort has been made in the empirical literature to determine the factors that affect the long-run demand for money and assess the stability of the relationship between these factors and various monetary aggregates. A large amount of research has been conducted on this topic (see Judd and Scadding [1982], Laidler [1985], and Goldfeld and Sichel [1990] for extensive surveys).The behavior of a money demand function in changing financial environment is a subject that has received increasing attention in recent years. The importance of the relation between financial development and money demand is illustrated by the voluminous literature that has investigated the affects of financial market changes response of real money balances to changes in real income and an opportunity cost measure.Researchers have approached this important issue that financial development plays a very important role in money demand by testing for a long-run equilibrium or cointegration relation between real balances, real income and an opportunity cost measure. Most papers examine the relation for developed countries. More recently, researchers have turned their attention to the affects of financial development in developing and transition economies.Among the various focuses of existing studies, two strands of studies are particularly notable. The first strand of studies examines the contention of Gurley and Shaw (1960) that financial innovations, by increasing the number of money substitutes, increase the interest elasticity of money demand. The second strand of studies focuses on observed rapid growth of equity markets and its effects on the money demand behavior.If financial innovation leads to unpredictable changes in the money demand function, policy makers' decisions may produce undesired consequences: if predicted money demand shifts are accommodated but do not occur, policy may produce demand shocks that affect output in the short-run and, if persistent, inflation over time.According to Friedman (1988), an increase in stock prices impacts on the demand for money through a positive wealth effect and a negative substitution effect. The positive wealth effect arises from the implied increase in nominal wealth, the portfolio adjustments from risky assets to safe assets and the increase in the volume of financial transactions. The negative substitution effect comes from the notion of the opportunity cost of holding money, where the increase in the equity prices makes the holdings of monetary assets less attractive.The presence of these possible influences of financial developments on money demand has important implications for monetary policies. In particular, if the Gurley and Shaw's contention is right, then monetary policies are rendered less effective for stabilization purposes. Additionally, failure to incorporate the stock market activities in the money demand function will result in model misspecification. Consequently, the monetary policies may faultily be tighter or easier than is appropriate for economic stability. As Thornton (1998) notes, the dominance of the wealth effect over the substitution effect, i.e. an increase in the stock prices means higher money holdings, requires easier monetary growth for a given target of a nominal income or inflation during periods of increasing stock market prices. By contrast, if the substitution effect dominates (i.e. the increase in the stock price...