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The demand for money in Korea: evidence from the cointegration test.

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Abstract

This paper shows that there exists a long-run equilibrium relationship between M2 and its determinants, real income and the long-term interest rate, in Korea by using Johansen and Juselius maximum likelihood cointegration method. However, M1 does not have any meaningful cointegration relationships with its determinants. The long-term interest rate is a better proxy than the short-term rate to measure the opportunity cost of holding money. Based on the results, a broad definition of money is a better measure than a narrow definition of money in considering the long-run economic impacts of changes in monetary policy in Korea. (JEL E41)

Introduction

This paper presents empirical work on the stability of the money demand function in Korea. Economists agree that a stable money demand function is crucial for the central bank's monetary policy to achieve its desired goals. This means that money supply would have some predictable impact on real variables only when the demand for money is stable. Therefore, it is very important to verify whether a stable relationship exists between the money demand and its determinants.

There are many studies that investigate whether there is a stable long-run relationship between money and its determinants, such as real GDP or interest rates, using a variety of econometric techniques. Previous studies such as Hafer and Jansen [1991], Miller [1991], and Hoffman and Rasche [19921 investigate the stability of the demand for money in the United States by using either the Engle-Granger [1987] two-step cointegration method or the Johansen [1988] and Johansen and Juselius [1990] multivariate cointegration method. The evidence in the above mentioned studies indicates that the broad definition of money (M2) aggregate is the preferable measure to implement monetary policy because M2 is cointegrated with income and the interest rate, while the narrow definition of money (Ml) is not.

Bahmani-Oskooee and Rhee [1994] (B-R) find that M1 is cointegrated with its determinants (while M2 is not) by using the regression-based Engle and Granger method for the case of Korea. Contrary to the results of B-R [1994], Lee and Chung [1995] provide the empirical evidence that M2 in Korea is cointegrated with its determinant (but not Ml) by using the maximum likelihood estimation.

The purpose of this paper is to determine whether Ml or M2 monetary aggregates have any long-run equilibrium relationship with its determinants in Korea by using a multivariate cointegration technique rather than the two-step cointegration technique. The reason is that the Johansen and Juselius [1990] method is preferred to the simpler regression-based Engle and Granger [1987] method, since it fully captures the underlying time series properties of the data, provides test statistics for the total number of cointegrating vectors, and permits direct hypothesis testing on the coefficients of the cointegrating vectors. In addition, its results are invariant with respect to the direction of normalization because it makes all of the variables explicitly endogenous.

The motivation to re-explore the stability of money demand function is that there few studies about...

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