The Stability of Money Demand Function in Sri Lanka: A Bound Cointegration Approach

Abstract

The importance of demand for money has become a prominent research topic in monetary economics due to its role in monetary policy formulation. This paper investigates empirically the determinants of money demand function in Sri Lanka over the period 1977-2019. This study estimates both short run and long run money demand function using monetary aggregates M1 and M2 based on time series data. The explanatory variables used in the study comprised with stability variables such as Inflation rate, exchange rate and Gross Domestic product, Opportunity cost variables such as short run interest rate and long term interest rate and other macroeconomic variables such as government expenditure, interest rate spread and economic crisis. Annual time series data has been taken to estimate eterminants of money demand. The estimates of the long run relationship is obtained by using bound cointegration technique and the vector error correction technique was used to estimate of the short run dynamics of the long run equation. Findings of the study confirmed real GDP, interest rate, government expenditure, inflation rate, interest rate spread and economic crisis has significant relationship with the money demand in Sri Lanka. According to the stability test, the empirical results show that the both M1 and M2 money demand functions are stable for the period 1977-2019. Results indicate that both M1 and M2 are suitable for the monetary policy formulation. Thus, Sri Lanka’s current practice of monetary targeting framework using broad money as an intermediate target is viable. This study provides the policy challenges that Sri Lankan economy meets to develop favorable macroeconomic environment in order to manage money demand for a sustainable growth.