An econometric analysis of the real demand for money in South Africa : 1990-2007

Abstract

A stable money demand function plays a vital role in the analysis of macroeconomics, especially in the planning and implementation of monetary policy. With the use of cointegration and error correction model estimates, this study examines the existence of a stable long-run relationship between real money demand (RM2) and its explanatory variables, in South Africa, for the period 1990-2007. The explanatory variables this study uses are selected on the basis of different monetary theories, including the Keynesian, Classical and Friedman‟s modern quantity theory of money. Based on these theories, the explanatory variables this thesis uses are real income, an interest rate, the inflation rate and the exchange rate. All variables have the correct signs, as expected from economic theory, except the inflation rate. Thus real income and inflation have positive coefficients, while the interest rate and exchange rate coefficients are negative. The results from unit root tests suggest that real income, interest rate and the inflation rate are found to be stationary, while RM2 and the exchange rate are non-stationary. Results from the Engle-Granger test suggest that RM2 and its all explanatory variables are cointegrated. Hence, we find a long-run equilibrium relationship between the real quantity of money demanded and four broadly defined macroeconomic components: real income, an interest rate, the inflation rate and the exchange rate in South Africa. Overall, the study finds that the coefficient of the equilibrium error term is negative, as expected, and significantly different from zero, implying that 0.20 of the discrepancy between money demand and its explanatory variables is eliminated in the following quarter. This evidence suggests that the speed of adjustment for money demand implies the money market in South Africa needs about four quarters to re-adjust to equilibrium. This observation agrees with the public statements of the South African Reserve Bank. Whether this will hold after November 2009 is the obvious subject of future research.