Factors Determining Money Demand In Malaysia

In this chapter the research will focus on the background of the research to give findings of past researchers, justification of the research, problems statement which is the gap which has been left out by other researchers, list of the objectives of the research and lastly state how the research will be organized.

Defining money demand function is a central concern for monetary policy makers, because the combination of money supply and money demand determines interest rates, and therefore affects the final goals of monetary policy. A stable money demand allows for better predictions of the effect of monetary policy on interest rates, output, and inflation, and therefore reduces the possibility of an inflation bias (Cziráky and Gillman, 2006). Stable money demand is a also precondition for an effective monetary policy, especially for countries pursuing a monetary targeting framework (Qayyum, 2005).

Demand for money has a close link with interest rates, real GDP, exchange rate and inflation. An increase in the federal funds rate and other short-term interest rates will reduce the attractiveness of holding money balances relative to higher-yielding money market instruments and thereby reduce the amount of money demanded and slow growth of the money stock, (M1, M2 and M3); this shows that money demand and interest rate have a negative relationship. A positive relationship is indicated by GDP and Demand for money, for example, the amount of money demanded, at any given interest rate, is Proportional to nominal income, as measured by nominal GDP. For example, if GDP increases by 10% then the demand for money increases by 10% as well, at any given interest rate.

Definition of terms

Money demand

The demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits. It can refer to the demand for money narrowly defined as M1 (non-interest-bearing holdings), or for money in the broader sense of M2 or M3.

Money supply

Malaysia follows a fixed exchange rate arrangement and does not have an explicitly stated nominal anchor for its monetary policy, but rather monitors various indicators

M1: the narrowest definition of money supply consists of currency outside banks plus checkable deposit plus traveler’s checks (currency held outside banks includes coins and paper money)

M2: A broader definition of money supply, it includes all of the components of M1 plus small-denomination time deposits plus savings deposits plus money market accounts plus other deposits.

M3

M2 + deposits with non-bank financial institution (e.g., deposit of finance companies and post office savings

REAL GDP

Is a macroeconomic measure of the value of output economy adjusted for price changes (that is, inflation or deflation)

Exchange Rate:. It is the value of a foreign nation’s currency in terms of the home nation’s currency. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date

CPI

It is the index that measures the average price level of goods and services typically consumed by households.

Interest Rate: An interest rate is the price a borrower pays for the use of money they do not own, for instance a small company might borrow from a bank to kick start their business, and the return a lender receives for deferring the use of funds, by lending it to the borrower. Interest rates are normally expressed as a percentage rate over the period of one year

BACKGROUND OF THE STUDY

Defining the money demand function is a central concern for monetary policy makers,

because the combination of money supply and money demand determines interest rates, and

therefore affects the final goals of monetary policy. A stable money demand allows for better

predictions of the effect of monetary policy on interest rates, output, and inflation, and

therefore reduces the possibility of an inflation bias (Cziráky and Gillman, 2006). Stable

money demand is a precondition for an effective monetary policy, especially for countries

pursuing a monetary targeting framework (Qayyum, 2005).

Definition of terms

Money demand

Money supply

Different Malaysian researchers have conducted studies on the factors determining money demand in Malaysia; below is the findings of their researches.

Monetary Policy Framework

Statement of the problem

Central bank sometimes face a problem in determining how much money should be injected in the economy due to unstable money demand function, besides that, the central does not know whether money demand function is stable and what factors are affecting the money demand function. If the central bank knows the factors affecting money demand function, the authorities of the central bank will be able to implement a sound and effective monetary policy

Research question

What are the factors determining money demand in Malaysia?

Do growth (GDP), exchange rate, consumer price index and interest rate affect money demand? What are the various relationships that exist between the dependent/explained variable and the explanatory/independent variables, that is, the relationship between monetary aggregates (M1, M2andM3) and GDP, exchange rate, CPI and interest rate (TBR3)?IS Malaysia money demand function stable, if not what are the causes

Research objectives

To examine the factors determining money demand in Malaysia

To examine Long- and Short-Run Determinants of the Demand for Money in Malaysia

To examine the impact of the exchange rate on the Malaysian money demand.

To find out how each of the variables influence monetary aggregates

To find if money demand function is stable, if not, what factors are affecting money demand function to be unstable

To use cointegration and error correction techniques to model the Malaysian demand for money over the 1970-2010 period and to examine the impact of the , (GDP), exchange rate, consumer price index and interest rate on the Malaysian money demand.

To determine the relationships that exist between the dependent/explained variable and the explanatory/independent variables, that is, the relationship between monetary aggregates (M1,M2 AND M3) and GDP, exchange rate, CPI and interest rate ( TBR3)?

To propose policy measures based on the findings of the study.

Significant of the study

This study examines factors determining money demand (M1, M2 and M3) in Malaysia. This is particularly important because the relation between the demand for money and its main determinants is an important building block in macroeconomic theories and is a crucial component in the conduct of monetary policy. It is also important in that the usefulness of a money demand function in the conduct of monetary policy depends crucially on its stability. The stability of the money demand function is crucial in that a stable money demand function would mean that the quantity of money is predictably related to a set of key economic variables linking money and the real economic sector, therefore, this will help central banks to select appropriate monetary policy actions based on the findings, the study also proposes policy intervention because policy makers are able to identify the significant variable that may have influence on the study, therefore being able to predict the demand behavior of the household and businesses in the financial system, thus accurately inject money in the financial system.

Literature Review

According to Sekaran (2000) literature review is the documentation based on the information from the unpublished which is the primary sources of data and the published which is the secondary source of data which is readily available. The information gathered have to be related to the study that is being conducted. Furthermore this research will use books, journals from computerized

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Some studies have been done using various measures of monetary aggregates on factors determining money demand in Malaysia, for example Marashden (1997) and Majid (2004). Goldfeld (1994) considers that the relation between the demand for money and its main determinants is an important building block in macroeconomic theories and is a crucial component in the conduct of monetary policy. As a result, the demand for money is one of the topical issues that have attracted the most attention in the literature both in developed and developing countries.

This is because a stable money demand function is an important issue in the monetary policy as it allows for better predictions of the effect of monetary policy on interest rates, output and inflation .Most of the researchers who carried their studies on money demand focused on the relationship between monetary aggregates which is M1, M2 and M3 with exchange rate and GDP, But there are some researchers who have included other variables such as interest rate, Consumer price index, inflation rate and Treasury bill rate.

The importance of the money demand function has encouraged a wide range of economists to empirically study its determinants and stability and the majority of the studies identified three main issues in their literature review relevant to modeling and estimation of demand for money. The three main issues are monetary aggregation, that is, the definition of money stock, appropriate scale and opportunity cost variables and functional forms. Most of the studies only examine one monetary aggregate, either M1,M2 ,M3or a combination of the 2, hence it is difficult to identify which monetary aggregates provides a better estimation of money demand function which will be used in implementing the monetary policy

1.According to Diu. H and Donald.W (2009) on the study based on determinates and stability of real money demand in Vietnam; interest rate, inflation, gross domestic product, gross national income and treasury bills has an effect on the demand for money. In the short-run only the interest rate has significant influence on changes of real money demand, while other variables do not affect money demand in short-run. Also the results on the study highlighted that the long-run is linked to the real demand for M2 with real income, consumer prices, the inflation rate which is measured by consumer price index (CPI) and the real effective exchange rate.

2.Abbas Valadkhaniet al (2008) in his study; Long- and Short-Run Determinants of the Demand for Money in the Asian-Pacific Countries: An Empirical Panel Investigation examined the long and short-run determinants of the demand for money in six countries namely China, Japan, Malaysia, Philippines, Singapore, and Fiji in the Asian-Pacific region using panel data (1975-2002). His results were found to be consistent with the theory whereby he found that the demand for money in the long-run positively responds to real income and inversely to the interest rate spread, inflation, the real effective exchange rate, and the US real interest rate. He also found that the long-run income elasticity is greater than unity and that both the currency substitution and capital mobility hypotheses hold only in the long run.

3. Muhd-Zulkhibri, A.Majid etl (2004) in his study, Reassessing The Stability of Broad Money Demand in Malaysia examined the impact of the effective exchange rate and the inflation rate on the demand for money in Malaysia and specified money demand function as real GDP, expected inflation rate, exchange rate and 3 month treasury bill rate .H e used M3 as the monetary aggregate in his model covering the period from 1974 to 2001 and found that money demand function is stable over the long run, but in the short run money demand is subject to disturbance of internal and external shocks. This is because of the presence of instability in 1992, 1994 and 1998 and it was mainly associated with large capital inflows. Money demand and M1 is co integrated with its determinants. In his results, he found that there is a negative relationship between the effective exchange rate and the m3.

4. Marashden etl (1997) on the other hand found that the money demand function is influenced by the expected inflation rate, income, 6 months deposit rate, seasonal dummies and expected rate of exchange rate. His study used cointergration and error correction to estimate the Malaysian money demand (M1) over the period 1980:1-1994:10 and his findings indicate that the error correction mechanism is a good representation of money demand in Malaysia and the study also supports the presence of currency substitution in Malaysia. In support of Majid (2004), Marashden also found that exchange rate has an impact in the Malaysian economy and should be taken into account. He urged that a negative relationship between exchange rate and money demand indicates that there is currency substitution phenomenon will occur and he was also supported by Majid(2004) who indicated that a negative relationship shows that the depreciation of Malaysian Ringgit would lead to the currency substitution. Most the studies as expected produced relevant results of the relationship between quantity of money demand and some economic variables.

5. Another study was conducted by Sanmi Babatope-Obasa et al (2004) who investigated the empirical relationship between broad definition of money, real income, interest rates, expected inflation and expected exchange rate and examined the constancy of this relationship in the light of economic reforms that had taken place in Nigeria for the period of 1987:1-1999:4 using the error correction frame. His result confirms a long-run relationship between real balances, income, interest rates, and inflation, and the significance of foreign interest rate and expected exchange rate indicates the presence of currency substitution. The results also find evidence of stability of both long-run and short-run money demand during the investigated period

6.The impact of real effective exchange rate on the demand for money in Malaysia is examined

by Marashdeh (1995). Marashdeh (1995) specifies the demand for money as a function of real

income, own rate of return, interest rate on alternative assets, real effective exchange rate, and

lagged money balances. He reports that the demand for narrow money is influenced by

income, 3-months t-bills, and lagged money balances; whereas M2 is influenced by real income, own rate of return (6-month mode deposit rate), 3-month t-bill rate and lagged money balances. He finds that real effective exchange rate has a negative impact in the short-run, whereas it has no impact in the long-run. However, his study does not check for the degree of cointegration among the variables, i.e., the presence of spurious correlation problem among the variables

7.Furthermore, a study by Thapelo Tsheole et al (2006) who examined the nature and stability of the demand for broad money (M2) in Botswana using real income, interest rate, South African treasury bill rate, inflation rate and US dollar/pula bilateral exchange rate found that the coefficients of real income, exchange and inflation rate have the expected positive signs and were significant in the long run, therefore the long run demand for money (M2) in Botswana was found to be positively affected by real income, inflation rate and exchange. He applied the multivariate cointegration approach as proposed by Johansen (1988) and Johansen and Juselius (1990) to estimate the relationship.

8. Moreover, another research on the Exchange Rate and the Demand for Money in Malaysia by M. Azali, Ahmad Zubaidi Ubaidi Baharumshah and Muzafar Shah Habibuliah supported the importance of exchange rate in M2 but not in M1 money demand. The study investigated the long-run relationship between exchange rate and money demand in Malaysia, and whether exchange rate can be considered as an additional determinant of the demand for money in Malaysia using using the likelihood ratio (LR) test proposed by Johansen and Juselius (JJ) (1990) and the Hansen Johansen (1993) likelihood ratio tests which found some evidence of instability in the long run parameters which was believed to be due to the recent financial crisis in this region. The analysis has provided support to the empirical investigation of the relation between exchange rate and money demand, meaning that in addition to the interest rate and

income, the demand for money is likely to depend upon the exchange rate,

9.Jelena Maravic , Mirjana Palic etl (2005) in their paper aiming at assessing the stability of the money demand function in the Republic of Serbia and provide an empirical analysis of factors that influence money demand mentioned that money demand could not be used for the purpose of targeting monetary aggregates because the results showed signs of instability over the entire period. The empirical analysis results show that both long- and short-term models of the demand for money function are well specified, but that the money demand was unstable, The cointegration analysis applying the Johansen procedure pointed to the strong cointegration between the real money, overall economic activity, inflation, and interest rates while The short-term (ECM) model shows that the money demand is still mostly affected by the expected inflation.

10.Another study by Ilhan Ozturk, Ali Acaravci (2008) examined the long-run determinants of the demand for money in ten transition countries using panel data for the 1994-2005 found that the demand for money in the long-run positively responds to increase in real income and negatively to a rise in the rate of inflation and the real effective exchange rate, and this was Consistent with theory. This means that real M2 is a predictable monetary aggregate. The feasible generalized least squares (FGLS) model was employed in the study.

http://www.jed.or.kr/full-text/24-2/ewing.PDF

http://psasir.upm.edu.my/3275/1/Exchange_Rate_and_the_Demand_for_Money_in_Malaysia.pdf

CHAPTER 3 RESEARCH METHODOLOGY

Introduction

This chapter includes ways of how data will be collected in the research about the topic, “FACTORS DETERMINING MONEY DEMAND IN MALAYSIA (1970-2010)”. Also it includes elements such as the theoretical framework, hypothesis development, sources of data, the model specification and variable specification, and lastly data collection and methods of analysis. Firstly it will represent a review of the theoretical framework, then the description of the hypothesis development. Some econometric techniques will be applied to achieve the objectives of the study

Theoretical framework

The main theories that explain the study of demand for money are: the classical quantity theory of money (which is explained by the Fisher’s equation of exchange); the Keynesian theory which explains the three motives for holding money, namely transactions, precautionary and speculative motives; the post-Keynesian theories of money demand, being the inventory-theoretic approach, precautionary demand for money approach, money as an asset approach (Buffer stock models) and consumer demand theory approach. The sections that follow discuss these theories, starting with the quantity theory of money, then the Keynesian theory and lastly the post-Keynesian theories.

1. The classical theory

Quantity theory of money

Is a theory of how the nominal value of aggregate income is determined because it tells how much money is held for a given amount of aggregate income .The most important feature of this theory is that it suggests that interest rates have no effect on the demand for money. The quantity theory of money explains the role of money as a medium of exchange. In this classical work, it is stated that money affects nothing but the price level. The quantity theory postulates a direct and proportional relationship between the quantity of money and the price level.

The equation of exchange in terms of the nominal value of transactions in the economy associated with Irving Fisher formulated the equation as

M*V=P*T

Where

M is the quantity of money in circulation

VT is the velocity of circulation or rate of turnover

P is the price level

T is number of transactions

The equation of exchange simply explains that total spending (MV ) equals what is bought, (PT)

It is an equilibrium condition which shows that money is held simply to facilitate transactions and has no intrinsic satisfaction.

2. Keynesian theory of money demand

In his famous book1936 book The General Theory of Employment, Interest, Money, John Maynard Keynes abandoned the classical view that velocity was constant and developed a theory of money demand that emphasized the importance of interest rates. In his arguments Keynes stated that individuals hold money for three motives: transactions, precautionary and speculative.

A. The transactions motive

He stated that money is there for the services it provides and to that transactions components of money demand Md ( Yf ) is a certain proportion of income. His view is similar to Fisher’s and the Cambridge approaches that individuals are assumed to hold money because it is a medium of exchange that can be used to carry out everyday transactions,e.g buying necessities like food. There is a stable relationship between the level of income and money demanded for transaction purposes

B. Precautionary motive

Keynes went beyond the classical analysis by recognizing that in addition to holding money to carry out current transactions, individuals also hold money for the purpose of investment. This means people hold money as a cushion against an unexpected need. Keynes believed that the precautionary money balances people want to hold are determined primarily by the level of transactions that they expect to make in the future and that these transactions are proportional to income, therefore he postulated the demand for precautionary money balances is proportional to income.

C. Speculative motive

Keynes took the view that people also hold money as a store of wealth, thus calling his reasoning for holding money the speculative motive because he believed that wealth is tied closely to income. Keynes also looked more carefully at other factors that influence the decision regarding how much money to hold as a store of wealth, especially interest rate.

According to Keynes, bonds were the alternative assets to holding money. Money provides zero interest, whereas bonds provide interest income and capital gain. The analysis of speculative motive depends on expectation in the movements of future interest rates. When interest rates rise, the price of a bond falls. Therefore, if individuals expect interest rates to rise, they expect the price of the bond to fall and hence suffer a negative capital gain. Money and bonds are considered perfect substitutes, according to this theory. Individuals can hold their wealth either in money or in bonds. The price individuals are willing to pay to acquire bonds depends on the rate of interest that will be earned. The introduction of interest rate in the money demand by Keynes led to the function being represented as follows:

Md = f (i,y)

Where

Md is the demand for real money balances

Y is real income

i is the interest rate.

The above equation ( liquidity preference function) shows that demand for money is a function of interest rates and income. According to Keynes, low interest rates will lead to high money demand because people will prefer to hold money and expect interest rates to increase, hence if there is a decrease in the price of bonds and no one would want to hold bond. The theory simply states that there is a negative relationship between money demand and interest rates

3. Post-Keynesian theories.

it can be concluded that these different demands for money theories share common important scale variables. They establish a relationship between the quantity of money demanded and a set of economic variables.

Hypothesis development

Hypothesis is used to test the relationship between variables. In this research the relationship will be tested between the dependent variable which is monetary aggregates (M1, M2, and M3) and the independent variable, GDP, exchange rate, CPI and interest rate (TBR3)

Some econometric techniques will be applied before analysis, first a stationary test will be performed using Augmented Dickey Fuller test (ADF) since time series data is used, and this is performed to make sure that the data is stationary and that the analysis provide good results.

Secondly, I will proceed to do cointergration analysis using Johansen cointergration test to tell whether there is a long run relationship existing within the variables, monetary aggregates (M1, M2, M3) with determinants, GDP, exchange rate, CPI , interest rate (TBR3), foreign direct investment(FDI) and current account(C/A).

Thirdly, causality test will be performed to examine whether the short run causality exist from the independent variables to dependent variable.

Lastly, Diagnostic checking will also be applied to check the following

1.

to ensure the model is free from the problem of homescedasticity (p- value), autocorrelation in residuals (using Breusch-Godfrey Serial Correlation, LM test (p- value) and also to test for normality in the residuals using Jargue Berra (p-value)

Model specification and variable specification

Demand for money is assumed to depend on a scale variable, the rate of return on

money, and the opportunity cost of holding money

Estimation of the model

Md = α0 + α1X1 +α2X2 + α3X3μ +α4X 4+ α5X5+ α6X6 +μ

Md = α0 + α1GDP + α2EXRATE+ α3CPI+ α4IRATE+ α5FDI +α6C/A + μ

Dependent variable:

Monetary aggregates (M1, M2, M3) =Md

Independent variables:

GDP = Gross Domestic Product

EXRATE = Exchange Rate

CPI = Consumer price index

FDI= Foreign Direct investment

C/A=Current account

Definition of terms

M1: the narrowest definition of money supply consists of currency outside banks plus checkable deposit plus traveler’s checks (currency held outside banks includes coins and paper money)

M2: A broader definition of money supply, it includes all of the components of M1 plus small-denomination time deposits plus savings deposits plus money market accounts plus other deposits.

M3

M2 + deposits with non-bank financial institution (e.g., deposit of finance companies and post office savings

REAL GDP

Is a macroeconomic measure of the value of output economy adjusted for price changes (that is, inflation or deflation)

Exchange Rate: It is the value of a foreign nation’s currency in terms of the home nation’s currency. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date

CPI

It is the index that measures the average price level of goods and services typically consumed by households.

Interest Rate

An interest rate is the price a borrower pays for the use of money they do not own, for instance a small company might borrow from a bank to kick start their business, and the return a lender receives for deferring the use of funds, by lending it to the borrower. Interest rates are normally expressed as a percentage rate over the period of one year

Current account is the sum of the balance of trade exports (net exports), net factor income and net transfer payments.

Foreign Direct investment is a measure of foreign ownership of productive assets, such as factories, mines and land.

Data collection

The model will be estimated by using 40 – yearly data which start from the year 1970 to the year 2010. The purpose of the chosen periods is to find out how well the stability of the Malaysian money demand function has been during the periods of financial crisis. Time series type of data will be used in this research.

Sources of data

International financial statistics (IFS)

Department of statistics Malaysia

Methods of analysis