An analysis of money demand stability in Rwanda.

Abstract

A stable money demand function and exogeneity of prices is at the core of planning and implementing a monetary policy of monetary targets. This thesis examines both the stability of M2 money demand and price exogeneity in Rwanda for the years 1980 to 2000. We estimate and test the elasticities of the determinants of Rwandan money demand function. We include in this demand function those variables which economic theory indicates must be part of any empirical investigation of money demand. All coefficients had the signs as required by economic theory. We estimate the money demand function for Rwanda using cointegration analysis and an error correction mechanism. The results show real income, prices and M2 to be cointegrated. We employ three tests to show that the estimated demand function for Rwanda is stable. We then test the second requirement for coherence in monetary aggregate targeting that money determines prices. The results show that prices are exogenous to money. But before we can definitely conclude that an inflation targeting regime is feasible from monetary policy perspective, we point out that future research on this important topic must account for exchange rate movements, measure permanent income and specify interest rate changes correctly.