6. Why are there lags in adjustment of money demand to its desired long run value?

Derive money demand functions using (a) first order partial adjustment model, and
(b) second order partial adjustment model.

ANS.

Why are there lags in adjustment of money demand to its desired long run value:
Lags often occur in the adjustment of money demand to its desired long-run value. There can be
several reasons for such lags. Among these are: (i) habit persistence and inertia, (ii) slow
adjustment of money balances due to uncertainty on whether the changes in the determinants
(income and interest rates) of money demand are transitory or longer lasting, and (iii) adjustment
costs, which can be monetary or non-monetary.
first order partial adjustment model:
One reason for an adjustment lag can be the short-run cost of changing money balances. To
investigate the relationship between such costs and the adjustment lag in money balances, let the
individuals desired real balances be mt and assume that the individual faces various types of
costs of adjusting instantaneously to mt. Examples of such costs are:

(43) and (44) constitute the first-order(i.e. with a one-period lag only)partial
adjustment model (PAM): the adjustment of real balances in period t is partial, linear
and involves a one-period lag. This model suffers from the disadvantage that if m*t
has a positive or negative trend, the divergence of actual balances from the desired
ones will increase over time. Individuals would find it profitable to avoid this by
abandoning the first-order PAM and using some other adjustment mechanism.
Therefore, the first-order PAM is inappropriate when the desired or actual balances
have a strong trend component. A higher-level PAM would be more appropriate in
such a case.
second order partial adjustment model:
Higher-order partial adjustment models result from more complicated specifications
of the adjustment costs. The second-order (i.e. with a two-period) partial adjustment
model is given by the adjustment cost function:

represents the cost of continual adjustments over time in balances. Minimizing (46)
that is, setting the partial derivative of c with respect to m equal to zero and
solving implies that:

Since (47) has a two-period lag, it provides the second-order partial adjustment
model.

5. Suppose permanent income can be expressed as a function of current

and past incomes. Derive a simple estimating form of permanent income
from this assumption. Derive an estimating form of the money demand
function using permanent income as an argument.
ANS
simple estimating form of permanent income:

In order to illustrate the application of adaptive expectations in money demand

estimation, we shall use permanent income as the income variable in the money
demand function. This function is:

The general adaptive expectations model assumes that the individual bases his
permanent income on his experience of current and past actual income, so that the
general function for permanent income ypt would be:

A simple form of (30), which has proved to be convenient for manipulation and
was used by Friedman for deriving permanent income in his empirical work on
consumption and money demand, is the adaptive expectations (geometric
distributed lag) function. It specifies the functional form of ypt as:

where 01. Permanent income is thus specified as a weighted average of current

and past incomes, with higher weights attached to the more recent incomes. Note
that if =0.40, a weight often cited as approximating reality for annual consumption
data, the weights decline in the pattern 0.4, 0.24, 0.144, 0.0864, , so that income
more than four years earlier can be effectively ignored. If actual income becomes
constant, permanent income will come to equal this constant level of actual income.
estimating form of the money demand function
Substituting ypt from (33) in the money demand function (11) gives:

7. Derive a money demand function assuming an autoregressive distributed lag

specification.
Suppose that the demand for real balances depends on the current and lagged values of real
income and its own lagged values. That is, it has the form:

so that mt becomes a function solely of yt and its lagged terms, without its own
lagged values, which are now omitted from the explanatory terms. (59) is the
compact form of the ARDL lag model.

While (60) and (63) are mathematical transformations of each other, so that their
economic content is identical, the money demand function in the form of (63) does
not contain the lagged value of the endogenous variable, although we started with
equation (60) where it does so. Conversely, we could have started with (63) without
the lagged money term and derived (60) as equivalent to it. Hence a comparison of
(60) and (63) and of (59) with (56) for the general case leads to the caution that
it may not be possible to distinguish between a money demand equation which
contains the lagged values of the endogenous variable and other independent
variables, and one which contains only the current and lagged values of the
independent variables.
The general ARDL model with the suitable addition of disturbance terms is now in
common usage in monetary analysis, and falls in the category of vector
autoregression (VAR) models.
8. What factors determine the demand for money in an open economy?
What is currency substitution? What factors determine the degree of
currency substitution in an economy? The elasticity of substitution is
greater and higher in developed countries but lower in developing
countries. Explain.
factors
For portfolio investments in open economies, the financial alternatives to holding
domestic money include the currencies and bonds of foreign countries, in addition
to domestic bonds, so that the determinants of the domestic money demand should
include not only the rates of return on domestic assets but also those on foreign

assets. Since these assets include foreign money holdings, money demand studies
for open economies need to pay special attention to substitution between domestic
and foreign monies. This determination is especially relevant for open economies in
which foreign currencies are extensively traded and foreign monies are part of the
domestic media of payments. Note that the relevant literature on substitution
between domestic and foreign money in the open economy uses the word
currency for money.
currency substitution
Currency substitution (CS) can be defined as substitution between domestic and
foreign currencies, which is currencycurrency substitution. Substitution can also
exist between domestic currency and foreign bonds, and between domestic
currency and domestic bonds, which are currencybond substitutions.
Designating, respectively, the nominal values

What factors determine the degree of currency substitution in an

economy?
The magnitude of CS will depend both on portfolio selection considerations-since
both M and M are assets in a portfolio-and on substitution between them as
media of payments in the domestic economy. Therefore, the relevant approaches to
the degree of CS are the portfolio/asset approach and the transactions approach.
For the asset/portfolio approach, the relevant theory would be the theory of portfolio
selection, which would treat M and M among the assets in the portfolio. This
theory would determine substitution between currencies on the basis of their
expected yield and risk. Two currencies would therefore be perfect substitutes if
they had identical returns. They would be poor substitutes if, with identical risk, the
return on one dominated that on the other. This identity of risk dominance does not
in general apply in practice. Note that if some types of bonds were riskless, then,
with a higher return, bonds would dominate over money, so that there would be
zero portfolio demand for currency.
For the transactions approach to the demand for media of payments, it is the
general acceptance in daily exchanges and payments that would determine the
degree of substitution between the alternative assets. If the foreign currencies do
serve as a medium of payments in the domestic economy, the classic demand
analysis for the total of the media of payments, i.e. for the sum of M and M , is the
BaumolTobin inventory analysis.
Under this approach, since domestic and foreign bonds do not serve as media of
payments they would have a relatively low substitutability with the domestic
currency,

The economic agents in even very open economies but without effective
dollarization tend to use the domestic currency as the preferred medium of
payments, the preferred habitat. Under this hypothesis, the degree of
substitutability between the domestic currency and a given foreign one would
depend on the latters acceptance for payments in the domestic economy or the
cost and ease of conversion from the latter into the former. In general, there would
be a very significant transactions cost in conversion. In retail transactions, payment
in a foreign currency is usually at an unfavorable exchange rate set by the retailer.
Consequently, under the preferred habitat approach foreign currencies will have low
elasticities of substitution with the domestic currency.