Stability of money demand and monetary policy in a small developing economy - Uganda : an econometric investigation into some basic issues.

Abstract

A stable money demand function is the essence of planning and implementing monetary policy. This thesis explores the stability of the M2 money demand function in Uganda for the period 1980-2002. We estimate and interpret the elasticities of the determinants of the money demand function. After analyzing the dynamics of money demand determinants, the variables crucial to money demand estimation in this thesis were established as being: real income, the nominal rate of interest on Treasury bills, the actual rate of inflation and the change in the exchange rate. All variables had the correct signs as required by economic theory, where real income was found to be positive whilst the nominal rates of interest on Treasury bills, the actual rate of inflation and the change in the exchange rate all have negative signs. We estimate the money demand function for Uganda, using cointegration analysis and an error correction mechanism (ECM) on quarterly data over the sample period 1980-2002. The results from the Johansen and Juselius (1990) cointegration test suggest that real income, the nominal interest rates on Treasury bills and real M2, are cointegrated. The results of the error correction mechanism suggest that in spite of major policy reforms in the years 1987 and 1993 such as the introduction of new financial instruments, and liberalization of the financial system, the estimated money demand function for Uganda is stable only in one time period 1994-2002 that is after major policy reforms. The results of the study show that M2 is a viable monetary policy tool that could be used as an intermediate target to stimulate economic activity in Uganda. We also conclude that the feasible approach for conducting monetary policy in Uganda is to adopt an inflationary targeting regime. However, monetary policy might continue to benefit from other economic indicators by monitoring the impacts of changes in interest rates and the change in exchange rates on real money demand in Uganda.