Tests of the functional form, the substitution effect, and the wealth effect of Mexico's money demand function.

• Author: Hsing, Yu
• Pages: 43(11)

Resumen. Las demandas M1, M2 y M3 en México son influenciadas positivamente por el producto y el precio de las acciones, y están asociadas negativamente con la tasa de ahorro, la tasa de interés estadounidense y la tasa de inflación esperada. Por su parte, la depreciación del peso afecta negativamente la demanda M1 y positivamente las demandas M2 y M3. La forma log-lineal no puede ser rechazada para la demanda M1 y puede ser rechazada para las demandas M2 y M3, mientras que la forma lineal puede ser rechazada para las demandas M1, M2, y M3. La prueba CUSUMSQ muestra que las demandas M1, M2 y M3 son estables; mientras la prueba CUSUM indica estabilidad en las demandas M1 y M3 e inestabilidad en la demanda M2.

Palabras clave: transformación de Box-Cox, sustitución monetaria, efecto riqueza, pruebas de estabilidad.

Clasificación JEL: E41, F41, O54.

Abstract. M1, M2, and M3 demands in Mexico are positively influenced by output and stock prices and negatively associated with the saving tate, the U.S. interest rate, and the expected inflation rate. Peso depreciation affects M1 demand negatively and M2 and M3 demands positively. The log-linear form cannot be rejected for M1 demand and can be rejected for M2 and M3 demands, while the linear form can be rejected for M1, M2, and M3 demands. The CUSUMSQ test shows that M1, M2, and M3 demands are stable; while the CUSUM test indicates stability in M1 and M3 demands and instability in M2 demand.

Key words: Box-Cox transformation, currency substitution, wealth effect, stability tests.

JEL classification: E41, F41, O54.

1. Introduction

   During the 1994-95 crisis, the Mexican peso suffered a substantial depreciation of 121.7%, the deposit rate rose to a high of 57.5%, the stock price plunged 43.5%, and the inflation rate rose 48.4%. Largely due to these developments, M1 declined from 145.1 billions in 1994.M12 to 109.7 billions in 1995.M5, while M2 and M3 were relatively stable or rising. It is significant to examine the demand for money for Mexico to have a better understanding of its behavior and impacts on the country's economic activities. This paper has several focuses. First, financial stock prices in Mexico have advanced a great deal in the last decade and may affect the demand for money negatively due to the substitution effect or positively due to the wealth effect (Friedman. 1988). The peso/USD exchange rate fluctuated in the short run and increased in the long run. The 1994-95 peso crisis caused significant concerns about how to protect peso-denominated assets from declining. The impact of peso depreciation on money demand may be negative due to the substitution effect or positive due to the wealth effect (Arango and Nadiri, 1981; MeKinnon, 1982; Bahmani-Oskooee and Malixi, 1991; Bahmani-Oskooee and Ng, 2002). Because the signs for the financial stock price and the nominal exchange rate in the money demand function are ambiguous, empirical estimation is required to determine whether a change in the stock price or the exchange rate would affect money demand negatively or positively. Second, the Box-Cox transformation (Box and Cox, 1964; Greene, 2003) is applied to determine which functional form is appropriate (Sarno, Taylor, and Peel, 2003). Most previous studies chose the log-linear form in empirical work partly because the coefficient is the elasticity. Whether the log-linear or linear form is appropriate may need to be tested. Third, comparative static analysis will be applied to find possible impacts of a change in the financial stock price or the nominal exchange rate in the money demand function on the equilibrium real output.

   Several seminal works (Tobin, 1958; Chow, 1966; Goldfeld, 1973, 1976; Judd and Scadding, 1982; Gordon, 1984; Laidler, 1990; Goldfeld and Siehel, 1990) have contributed substantially to the understanding of the demand for money. Small and Porter (1989), Hetzel and Mehra (1989), Hafer and Jansen (1991), Mehra (1993, 1997), Duca (2000), Carlson, Hoffman, Keen and Rasche (2000), and others examined the behavior and stability of M2 for the U.S. For example, Mehra (1997) indicated that the demand for M2 shifted leftward during the early 1990's and that the behavior of M2 has remained relatively stable since 1994 and may be useful for the analysis of monetary policy. Duca (2000) showed that the decline in M2 and the rise in M2 velocity in the early 1990's were matched by the increase in bond mutual funds. He suggested that M2 demand can be modeled better if the market for bond mutual funds is also taken into consideration. Sarno, Taylor, and Peel (2003) indicated that the money demand function for the U.S. was stable during 1869-1997 and that there existed a nonlinear relationship that was adjusted toward long-term equilibrium.

   There are several recent studies of the demand for money for Mexico or neighboring countries. Bahmani-Oskooee and Malixi (1991), based on the C how test, found that M1 demand in Mexico had a structural break in 1979 and that it had a positive relationship with real output and a negative relationship with the effective exchange rate and the inflation rate...